Prologis - Q3 2023

Transcript

Operator (participant)

Greetings, and welcome to the Prologis Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Jill Sawyer, Senior Vice President of Investor Relations. Thank you, Jill. You may begin.

Jill Sawyer (SVP of Investor Relations)

Thanks, Sean, and good morning, everyone. Welcome to our third quarter 2023 earnings conference call. The supplemental document is available on our website at prologis.com under Investor Relations. I'd like to state that this conference call will contain forward-looking statements under federal securities laws. These statements are based on current expectations, estimates, and projections about the market and the industry in which Prologis operates, as well as management's beliefs and assumptions. Forward-looking statements are not guarantees of performance, and actual operating results may be affected by a variety of factors. For a list of those factors, please refer to the Forward-Looking Statement Notice in our 10-K or other SEC filings. Additionally, our third quarter results, press release, and supplemental do contain financial measures such as FFO and EBITDA that are non-GAAP, and in accordance with Reg G, we have provided a reconciliation to those measures.

I'd like to welcome Tim Arndt, our CFO, who will cover results, real-time market conditions, and guidance. Hamid Moghadam, our CEO, and our entire executive team are also with us today. With that, I'll hand the call over to Tim.

Tim Arndt (CFO)

Thanks, Jill. Good morning, everybody, and thank you for joining our call. The third quarter marked a continuation of themes we've been anticipating for more than a year, namely, growing supply translating to increased market vacancy, continued moderation of demand, and market rent growth that will slow until the low levels of new starts drive reduced availability over time. We've operated in accordance with these views in both our approach to leasing as well as timing of new development. What's incremental to our forecast is that continued hawkish posture from central banks and the impact it's had on rates is delaying decision-making and willingness to take expansion space early. The geopolitical backdrop has clearly become more troubling as well, amounting to a lack of clarity that will likely weigh on demand.

In the meantime, and also playing out to our expectation, is that our existing lease mark-to-market will drive durable earnings growth, as it did in delivering record rent change this quarter, as well as strong earnings and same-store growth. We remain focused on the fact that we own assets critical to the supply chain, with long-term secular drivers that remain intact. Further, the outlook for future supply will continue to face structural barriers, ultimately driving occupancy rents and values. In terms of our results, we had an excellent quarter with Core FFO, excluding net promote income of $1.33 per share. This result includes approximately $0.03 of one-time items related to interest and termination income, as well as the timing of expenses, which we can address in Q&A. Occupancy ticked up over the quarter to 97.5%, aided by retention of 77%.

Net effective rent change was a record 84% at our share, with notable contributions from Northern New Jersey at 200%, Toronto at 187%, and Southern California at 165%. Same-store growth on a net effective and cash basis was 9.3% and 9.5%, respectively, driven predominantly by rent change. We saw market rents grow roughly 60 basis points during the quarter, the slower pace embedded in our forecast. In combination with the strong build of in-place rents, our lease mark-to-market recalculates to 62% as of September. We raised approximately $1.4 billion in new financings at an average interest rate of 3.2%, comprised principally of $760 million within our ventures, as well as a recast of our yen credit facility, increasing our aggregate line availability.

In combination with our cash position, we ended the quarter with a record $6.9 billion of liquidity. Finally, it's noteworthy that our debt to EBITDA has remained very low and essentially flat all year, hovering in the mid-4x range despite our increased financing activity, a demonstration of the tremendous growth in our nominal EBITDA. Turning to our markets. While rising, vacancy remains historically very low in the U.S., Mexico, and Europe. Market vacancy increased approximately 70 basis points during the quarter in the U.S., driven by low absorption as well as recently delivered but unleased completions. Europe experienced similar dynamics, with an overall increase in market vacancy of 50 basis points. At the macro level, our expectations for the U.S. are for completions to outpace net absorption by a cumulative 150-200 million sq ft over the next three quarters.

Then, over the subsequent three quarters, we see that trend reversing, with demand exceeding supply and recovering a net 75-125 million sq ft. That trend may extend further into 2025, as we believe development starts over the next several quarters are likely to remain low. Whatever the precise path, we expect that as vacancy normalizes over the long term, our portfolio will outperform the market due to both its location and quality, as well as the strength of our relationships and operating platform. In this regard, our portfolio has been largely resilient to moderating demand. Our teams would describe the depth of our leasing pipeline as consistent with the last few quarters. Coming fresh off of one of our customer advisory board sessions, it's clear that our customers have plans to continue to expand their footprints, increasing capacity and resiliency.

However, what's also clear is that they are slowing such investments until there is more clarity in the economic environment. In the U.S., rents increased in most of our markets, with the strongest located in the Sun Belt, Mid-Atlantic, and Northern California region. Europe and Mexico were also bright spots for growth in the quarter. Rents across our Southern California submarkets declined approximately 2% as it continues to adjust to higher levels of vacancy. While the markets and outlooks are mixed, we remain confident in continued market rent growth in the U.S. and globally over the coming year, albeit at a slower pace while the pipeline continues to get absorbed. From our appraisals, U.S. values declined approximately 3%, while European values remained stable, in fact, having a very modest write-up.

The difference isn't too surprising, as the Fed's language around inflation and the economy has had more effect in the U.S. capital markets, driving the 10-year up 100 basis points since our last earnings call, compared to the bond at just 50 basis points. We believe that this is likely another instance, as we saw one year ago, where U.S. appraisals at the end of the quarter have not had sufficient time to react to the increase in rates, and we are thus pausing on appraisal-based activity in USLF for at least one quarter. Elsewhere, values in Mexico are up 8.5%, while China experienced its first meaningful decline of 6.5%, a write-down that we don't believe has fully run its course.

Our funds experienced their first quarter of net positive inflows, with approximately $180 million of new commitments versus new redemption requests of $115 million. Given other activity in the quarter, the net redemptions have been reduced from their height of $1.6 billion to approximately $700 million, or roughly 2% of third-party AUMs. In terms of our own deployment, development starts ramped up during the quarter, crossing $1 billion, over half of which is related to a data center opportunity in our central region, a testament to our higher and better use strategy and strategically located land bank.

Also notable is the acquisition of $118 million of land, including a strategic parcel in Las Vegas, which will build out an additional 10 million sq ft over time and brings our total build-out of land globally to over $40 billion. We are laser-focused in identifying and executing on value creation in our core business, our energy business, and their adjacencies. Combined with the debt capacity and liquidity we've worked hard to build and preserve, we see the environment as rich with opportunity. Moving to guidance, we are increasing the average occupancy to range between 97.25% and 97.5%. As a result, we are increasing our same-store guidance to a range of 9%-9.25% on a net effective basis, and 9.75%-10% on a cash basis.

We're maintaining our strategic capital revenue guidance, excluding promotes, to a range of $520 million-$530 million, and adjusting G&A guidance to range between $390 million and $395 million. Our development start guidance is increased to a new range of $3 billion-$3.5 billion at our share, driven primarily from the data center start mentioned earlier. We had $500 million of contribution and disposition activity during the quarter, and given our commentary on USLF valuations, we are pausing our planned contributions into that vehicle this quarter and reducing our combined contribution and disposition guidance to a range of $1.7 billion-$2.3 billion. In the end, we are adjusting guidance for GAAP earnings in a range of $3.30-$3.35 per share.

We are increasing our Core FFO, including promotes guidance, to a range of $5.58-$5.60 per share, and are increasing Core FFO, excluding promotes, to a range between $5.08 and $5.10 per share, growth of nearly 10.5%. I know that many of you are focusing on 2024, so I'd like to take an opportunity to remind you that the Duke portfolio will be entering the same-store pool in 2024, which will widen the recently observed delta between net effective and cash same-store growth. This is, of course, because Duke rents were mark-to-market at close one year ago, so its contribution to net effective same-store growth and earnings will be minimal, even though the cash rent change will be on par with the rest of the Prologis portfolio.

In closing, we are navigating the current environment, assured that whatever the economy brings in the short term, we are positioned to outperform over the long term. This stems from not only the premier logistics portfolio and customer franchise with one of the best balance sheets among corporates, but also highly visible earnings and portfolio growth ahead of us. We know that turbulent times can bring opportunity for those who are prepared, and that's been central to our strategy and management as a company. I'd like to also remind you of our upcoming investor forum on December 13 in New York, our first in four years. We're looking forward to spending the day with you, sharing more about our business, outlook, and opportunities ahead. Additional information is available on our website and in our earnings press release.

With that, I will hand it back to the operator for your questions.

Operator (participant)

Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate that your line is in the queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please, while we pull for questions. The first question comes from the line of Michael Goldsmith with UBS. Please proceed with your question.

Michael Goldsmith (Equity Research Analyst)

Good morning. Thanks a lot for taking my question. I mean, Tim, can you help us reconcile some of the comments from the prepared remarks? You, you talked about maybe softer demand, but then there's a... You're calling for accelerating the number of build-to-suit developments. At the same time, occupancy has been stronger than anticipated, and that's before the lower development starts hit the market. So how should we think about all of these moving pieces and just the trajectory of, of the supply-demand dynamics kind of as we exit 2023 and into 2024? Thanks.

Hamid Moghadam (Chairman and CEO)

Sure. Demand is definitely softer. It's closer to normal, maybe even a little bit below normal at this instance. There is a lot of latent demand that large companies having large requirements are continuing to talk to us about build-to-suits, but they're reluctant to pull the-

Operator (participant)

The next question comes from the line of Craig Mailman with Citi. Please proceed with your question.

Craig Mailman (Director and Equity Research Analyst of Real Estate and Lodging)

Hey, guys. Let me know if you're having trouble hearing me, because I'm having trouble hearing you. But, just wanted to touch on the data center build-to-suits in the quarter and see if you guys could break out what the yields on those were relative to the blended yields on the overall development starts. And maybe just give a little bit more color about the opportunity with your partner on this one, the plans on whether you're going to hold this or anticipate selling it upon completion, and then, you know, just a little bit more about the capacity within the land bank to do more of these data center shells.

Operator (participant)

Ladies and gentlemen, please remain on the line. We're just having a little technical difficulty here. Thank you. Please remain on the line.

Hamid Moghadam (Chairman and CEO)

I'm sorry, we're having some technical difficulties here, and I can't really explain it.

Operator (participant)

Hello.

Hamid Moghadam (Chairman and CEO)

Can you guys hear? You can hear me again. Okay. So let me finish the first question, and then I'll go to the second question, to the extent I heard it, which wasn't great. On the first question, what I wanted to say is that the data centers account for a pretty significant volume of the build-to-suits, and that's why they're higher. But industrial logistics build-to-suits are kind of on par and in line with our expectations. The reason occupancy is higher, it's unique to the quality of our portfolio and just the natural roll of leases, but market occupancy is slightly lower, so we're outperforming the market by more than we did before. I think that covers the first question.

The second question was, how should we think about the build-to-suits in terms of its effect on our going-in yields and the like? And for that, I'm going to turn it over to Dan here. But generally, the build-to-suit strategy of ours is an extension of our higher and best use strategy. We own a lot of high-quality land in markets that are in the path of development and are popular data center markets. And while we may occasionally buy land for data centers, our primary strategy is converting our existing portfolio to data center products. To the extent they have power availability, we're getting a lot of people knocking on our door for those opportunities.

And we think going forward, it's gonna be a pretty significant part of our activity, although it's lumpy and less prone to precise predictions like the logistic business. But you'll hear more about that. Now, strategically, this is important to understand, we funded our business without issuing any equity, basically since 2012. Last 10 or 11 years, we have not issued any equity. How we finance our business is by disposing of real estate that was non-strategic to us, logistics real estate, and we've done a lot of dispositions. You can think of the data center strategy as a way of funding our growth. That's where the growth capital is gonna come from. We are not, at the moment, interested in being in that business for... in terms of long-term ownership.

It's more of a development and harvest strategy, and that capital that comes out of the margins of those deals will be a substantial contributor to our growth going forward. Dan, you want to talk about the initial yields on the data center?

Michael Goldsmith (Equity Research Analyst)

Well, what I would say is on this particular data center, we're under a strict confidentiality, so we can't be speaking about any particular deal points by any means. But what I would say is, we've been building capabilities internally to ensure that we hit the market for these deals, and you'll see those play out as we announce more data centers going forward.

Hamid Moghadam (Chairman and CEO)

What I would say generally, though, without getting specific on this opportunity, we think the margins that come out of our data center business, by definition, based on our historic costs of land or even the market value of land, will be orders of magnitude higher than they would be under a logistics build-out. So multiples of a normal margin.

Operator (participant)

The next question comes from the line of Steve Sakwa with Evercore ISI. Please proceed with your question.

Steve Sakwa (Senior Managing Director and Senior Equity Research Analyst on REITs)

Yeah, thanks. Good morning. I just wanted to follow up on the development and just make sure I understand. On the fourth quarter, you know, I think you've got something like $1.9 billion of planned starts, given that, you know, you've done about $1.4 billion year to date. So just curious, does that include other data centers or is that all traditional industrial? And if so, you know, what is the mix between spec and build-to-suit on that fourth quarter starts volume? Thanks.

Dan Letter (President)

Sure, Steve, this is Dan. So the lion's share of our Q4 starts are logistics starts. We have one, maybe two small, smaller data center starts that we have forecasted. But overall, it's about 50/50 build-to-suit and spec. And let me just highlight that we've been calling for a back-end loaded forecast for about 4 quarters now. As you've—as we talk about market development starts now at 65%, I guess, down 65% from the peak. This is playing out exactly as we expected, and we've been gearing up all year for a really heavy Q4 start volume.

Hamid Moghadam (Chairman and CEO)

Yeah, the portion of build-to-suits is obviously a lot higher than that if you include the data centers. What Dan meant was a mix of logistics and logistics spec versus build-to-suit.

Dan Letter (President)

Correct.

Operator (participant)

The next question comes from the line of Todd Thomas with KeyBanc Capital Markets. Please proceed with your question.

Todd Thomas (Equity Research Analyst)

Hi, thanks. Question, you know, as you think about 2024, Tim, you mentioned that market rent growth increased 60 basis points, relative to last quarter. That's down from 2.5% last quarter. I think you indicated that market rent growth is expected to be positive in the year ahead. You know, as we think about the trajectory of rent growth and what you're anticipating, do you see potential for sequential or year-over-year decreases in market rents in the U.S. or globally over the next few quarters as deliveries outpace absorption? Or do you expect rent growth to stay positive, you know, throughout that period, during that time frame?

Chris Caton (SVP, Managing Director, and Global Head of Strategy and Analytics)

Hey, Todd, it's Chris Caton. Thanks for the question. Yes, we expect rent growth to remain positive throughout that time period. Market conditions are, are stable, and there are a handful of markets that we've talked about that are softer, but by and large, markets are proving resilient with, with rent growth in line or ahead of inflation.

Operator (participant)

The next question comes from the line of Caitlin Burrows with Goldman Sachs. Please proceed with your question.

Caitlin Burrows (VP of REITs Equity Research)

Hi, everyone. Maybe we could talk about property acquisitions a little. I know it's not as large of an activity as developments, but guidance for this year increased while transaction volumes at an industry level are down significantly. You did the $3 billion acquisition mid-year. So what sorts of acquisitions are most interesting to you today? Could you talk a little bit about who you're buying from, maybe why they're selling, and how you get comfortable on what the right price should be?

Hamid Moghadam (Chairman and CEO)

Sure. You know, it's a dynamic market, and I think that's the essence of your question. It's really hard to get a handle on what the returns should be and how we look at acquisitions. But here is a model for thinking about it. First of all, we are even pickier than we have been with respect to quality and fit with our portfolio. We're not. Before, you know, you had to buy the good with the great in portfolios, and we had to go through the massive exercise of disposing of the properties that we didn't want, which we did actually quite successfully in a declining cap rate environment, and we actually made money on it. But we don't expect that to be the case going forward.

So we're really being picky about what we buy. The portfolios that we're going to buy are almost virtually 100% whole portfolios. Secondly, if you really think that, look at where treasuries are, 150 basis points have gone to, call it, 4.5%, 300 basis points increase. Those kinds of properties, core properties, were trading in the high 5s, low 6 IRRs. Let's stay away from cap rates because of a mark-to-market complexity of talking about cap rates, but call it 6. So just adjusting for the change in treasury yields, simplistically, you would have to see a 9 unleveraged IRR, and that's if supply and demand of capital were sort of in equilibrium.

We get a sense that there's gonna be more opportunities coming our way, and it is in a capital constrained environment, and we happen to be in a fortunate position of having a really good balance sheet and able to take advantage of those. I don't think there's gonna be distressed in the terms of a post savings and loan crisis or any of the downturns, but I think the opportunity set is gonna exceed the available capital, and I think we'll be taking advantage of that. So I would say unleveraged IRRs that have a 9 handle on them and maybe as much as 9-9.5, depending on the circumstances. And we are seeing that supply loosen up and come to the market.

Expect to see more transactions in the next six months. Dan, do you, do you have anything to add?

Dan Letter (President)

The only thing I would add is, you know, our teams around the globe are literally turning over every stone daily. This is land acquisitions, this is core acquisitions, it's value add acquisitions, and the teams turn to opportunistic right now, and so it's really hard to peg exactly where we're gonna land our acquisition volume for the year, which is why you saw us move it up a couple hundred million after this Phoenix transaction.

But, overall, I think our teams are gonna continue to find opportunistic transactions, consistent with what Hamid just said on the returns.

Operator (participant)

The next question comes from John Kim with BMO Capital Markets. Please proceed with your question.

John Kim (Senior Equity Research Analyst on U.S. REITs)

Thank you. I just wanted to clarify: so you're expecting over the next few quarters, a significant demand shortfall, and I'm wondering if during that time period, are you planning to be more aggressive on rents and concessions to try to hold occupancy, or are you gonna hold rates, just given supply is gonna start to come down after that? And also, if you could provide an update on the market rental forecast for 2023.

Hamid Moghadam (Chairman and CEO)

Yeah, on the rentable forecast, I'm afraid you're gonna have to wait for that when we issue guidance, and we get into that. And, you know, one thing we're gonna stay away from is quarter by quarter forecasting of rents. It's hard enough to guess what it is on an annual basis, much less, on a quarter-to-quarter forecast. So what was the first part of the question?

John Kim (Senior Equity Research Analyst on U.S. REITs)

Uh-

Hamid Moghadam (Chairman and CEO)

Oh, occupancy trade-off. It depends on the, on the actual markets. There are about 20% of the markets that I can see us driving for occupancy and about 80% of the markets that are still in equilibrium or tighter. But the key to your question is what, what you asked in the middle of it, which is: how do you expect that to change? And the reason we're not gonna get super aggressive on rents is because we have a belief that... I mean, just look at the starts. They're down 65%, and even with moderating demand, we're gonna get something like 60% or 70% of that shortfall that we're gonna encounter in the next three quarters, shortfall of demand, we're gonna get it back in the subsequent three quarters. So there's no sense really going cheap. It's just...

But in, I would say, 20% of our markets, we're gonna be more focused on occupancy.

Operator (participant)

The next question comes from the line of Nicholas Yulico with Scotiabank. Please proceed with your question.

Nicholas Yulico (Managing Director and Head of U.S. REITs Research)

Oh, thanks. Just a two-parter on Southern California. So I guess first, I want to see if you, you know, you're seeing any benefit in your portfolio since September in terms of the, you know, the port being resolved, the worker strikes, you know, impacting, you know, L.A. Basin or Inland Empire, if you're seeing any benefit there and pickup in activity. And then secondly, just wanted to hear your latest thoughts on, you know, why you think, you know, some of the weakness that you've cited there in rents in Southern California, what that dynamic is out there that would, you know, be different than other markets, meaning that, you know, Southern California is not a leading indicator for, you know, other parts of your portfolio.

Hamid Moghadam (Chairman and CEO)

Well, Southern California is very geared towards basically inflows. 40% of the inflows into this country came through Southern California, and that number dropped dramatically because of the labor issues. It's too soon to see any recovery because we're also going into the Christmas season, and anything that's gonna be in a store for Christmas has already been on the water and through the ports and all that. So I think you're gonna see the effects of that next year in terms of recovery of flows. About half of what used to come through L.A. used to stay in the L.A. Basin in Southern California, and half of it was shipped elsewhere.

We think the half that stays in Southern California, for sure will stay there or come back, and some of, some of the rest will also revert back to Southern California. I'm not smart enough to know whether we're gonna get half of it back or three-quarters of it back, but we'll get a pretty substantial portion of it back. It will be more into the first or second quarter of next year before you see it in the numbers. Chris, you want to add anything?

Chris Caton (SVP, Managing Director, and Global Head of Strategy and Analytics)

Yeah, I'll build on that by saying, as the market is digesting the demand and supply picture that Hamid described, we are beginning to see some differentiation in submarkets where, L.A., Orange County is proving, more resilient and Inland Empire is a bit softer.

Operator (participant)

The next question comes from the line of Camille Bonnel with Bank of America. Please proceed with your question.

Camille Bonnel (Equity Research Analyst)

Good morning. First, a clarification, then I want to get your thoughts on guidance. Can you clarify if the SoCal market rent change in the opening remarks is on a sequential or annual basis? And then, appreciate majority of your leasing for 2023 has been addressed, and there's little that could change your core outlook from here. But want to better understand the level of conservatism being factored into guidance looking into year-end. What could change your views more positively or negatively? Thank you.

Tim Arndt (CFO)

Hey, Camille, it's Tim. Yeah, just a clarification on the first part. That was a quarter-over-quarter number in SoCal, the 2% decline. And then in terms of what could change the fourth quarter, the answer is very little at this point. You know, certainly on the rent change side of things, most all of that leasing is already inked. We could have some surprises, very moderate, I would say, on the occupancy side, but I actually don't expect that. We've a pretty tight range on occupancy, as you know. So, I don't think you'll see anything take us outside of our guide.

Operator (participant)

The next question comes from the line of Ron Kamdem with Morgan Stanley. Please proceed with your question.

Ronald Kamdem (Managing Director and Head of U.S. REITs Research)

Hey, just a quick two-part follow-up. Just one on the development starts and the data centers, which is intriguing.

Any way to put some numbers on that, on how many starts can be done annually? Is it 200 million? Is it 500 million? Like, how big can this get? Is the follow-up, number one. And then number two, on sort of the rent growth. Appreciate we want to stay away from sort of specific numbers, but as you're sort of thinking about next year, what are sort of the key markets, Southern California being one, potentially being sort of a headwind? Maybe can you talk about what are some of the, you know, the neutral or potential tailwinds in terms of markets for next year? Thanks.

Hamid Moghadam (Chairman and CEO)

Okay. Your first question was great advertising for our investor day, because that's what we're gonna devote the time to, is understanding our essentials business, our data center business, and all those things. So let me defer answering that question to that date. And by the way, I, even on that date, you're not gonna get as specific an answer as you would like. I just tell you that in advance, because these are very lumpy, and it depends what quarter or what year a deal lands in. Chris, do you want to address the second part?

Chris Caton (SVP, Managing Director, and Global Head of Strategy and Analytics)

Yeah, absolutely. You know, I might start by just saying one way to think about rent growth going forward is to think about the replacement cost math. We have really seen construction costs prove resilient and replacement costs prove resilient. And the interest rate dynamic that Hamid described earlier translates to the rents that are required to warrant new development. So over a medium-term horizon, couple years, that's gonna play one of the most important factors into evaluating rent growth. As it relates to different markets, which was your question, I think it's probably fair to point to Tim's comments on the markets that have proved the strongest so far this year.

Mid-Atlantic, Sun Belt, Northern California, are markets that stand out in my mind in the U.S., and there is a range of them globally, whether it's Toronto, Mexico, Germany, and the Netherlands. So that's what I would look to.

Operator (participant)

The next question comes from the line of Anthony Powell with Barclays. Please proceed with your question.

Anthony Powell (Equity Research Analyst)

Hi, good morning. I guess one more on market rent growth. I think last quarter you gave a 2023 forecast of 7%-9%. I don't know if you updated that today, and are you gonna be providing those and kind of updated on a quarterly basis going forward?

Chris Caton (SVP, Managing Director, and Global Head of Strategy and Analytics)

So hey, the view is 7% in the United States globally and in the US. We're about mid-60s so far this year, so that implies growth in the fourth quarter, as we described earlier. And then, as it relates to forward guidance, I'd like to underline our upcoming Investor Day in December as the time to look for new information.

Operator (participant)

The next question comes from the line of Michael Carroll with RBC Capital Markets. Please proceed with your question.

Michael Carroll (Maanging Director and Head of U.S. Real Estate Research)

Yeah, thanks. How does the 150-200 million sq ft gap between supply and demand over the next three quarters compare to your expectation for all of 2023? Now, correct me if I'm wrong, I believe that you highlighted that there was gonna be about a 150 million sq ft gap in 2023. I mean, is that still a fair assumption, or has this delay in demand due to the market uncertainty has kind of widened that out a little bit?

Chris Caton (SVP, Managing Director, and Global Head of Strategy and Analytics)

Hi, thanks for the question. Again, it's Chris. So just to give you the total numbers, we are on pace to see 490 million sq ft of deliveries in the United States this year, against 195 million sq ft of net absorption. So that gap is wider. And some of that relates simply, not so much to the softness in demand that you're describing, but the timing of deliveries of the pipeline. If anything, our view of where the pipeline's going has come down, not gone up, over the last 90 days related to the trend and starts. And so really it's really timing as it relates to that gap.

Hamid Moghadam (Chairman and CEO)

Yeah, but I would say our, our previous forecast did not anticipate the sudden jump in rates that has come in the last month and a half. You know, we thought that treasuries were gonna settle in the mid 3s, not mid 4s. Maybe mid to high 3s, and not mid 4s, or approaching 5. So that, I think, has taken and shifted some of the demand out. But the thing that encourages me, and we'll have to wait to see this, is that companies are not shutting down their dialogue with us in terms of their long-term needs. And our build-to-suit discussions are every bit as good as they've been, you know, across most cycles.

But they're not pulling the trigger just yet, given that those things generally involve major capital expenditures, and those are all being scrutinized by the C-suite pretty, pretty tightly these days.

Operator (participant)

The next question comes from the line of Vikram Malhotra with Mizuho. Please proceed with your question.

Vikram Malhotra (Managing Director, Senior Equity Research Analyst, and Co-Head of US REITs Research)

Thanks. I just wanted to get a, you know, better sense of... You talked about deferring growth, I guess, across SoCal and rent growth across SoCal, Mid-Atlantic, I think you referenced Sun Belt. Can you just give us a better sense of the magnitude of this dispersion? And I guess, Chris, do you expect this dispersion to continue over the next, call it, 6-12 months?

Chris Caton (SVP, Managing Director, and Global Head of Strategy and Analytics)

So the magnitude of the dispersion. So just to be clear, in terms of strengths versus weaknesses, because I, I want to be sure that wasn't conflated. The strong markets include the Mid-Atlantic, Sun Belt, Northern California, and really, there are only a handful of soft markets. SoCal, we've talked about. Indy is a market that's been flat all year. In terms of dispersion, there is a fair amount of sameness in the trend, whether you look at it on a quarterly or a calendar year basis. So, rents are trending in that annualized rate from the third quarter that Tim discussed, with some markets moderately ahead, like the strong markets I described, and then just really one or two markets that are notably weaker. So I guess, I suppose there's that dispersion.

Operator (participant)

The next question comes from the line of Mike Mueller with JPMorgan. Please proceed with your question.

Mike Mueller (Senior Equity Research Analyst in REITs)

Yeah, hi. I know you know you've used land in the past for higher and better uses, but do you think you'd be looking at these data center developments to the same degree that you would be looking at them if you weren't seeing a normalizing of a traditional industrial demand?

Hamid Moghadam (Chairman and CEO)

Absolutely, because the margins embedded in the data center development, Mike, are orders of magnitude higher, certainly on the basis of market value under industrial use or purchase price under industrial use. So we would be doing that even if the market was tight as a drum. And by the way, let's not get carried away. The market is in the high 4s occupancy - I mean, vacancy. Sorry, that is, you know, absent 2021 and 2022, I would have said that would be my, you know, my Christmas present would be, you know, vacancy rates that are sub-5 in any part of the cycle other than the last couple of years.

So, so the markets are strong, but the data center opportunities, if you can get the power, the demand is there, and it's been sort of boosted by AI and a bunch of other things. So we see sort of a rush of, of the large players, and, and they're all big credit players into the business, and, and they can't get enough of this stuff to keep up with demand.

Operator (participant)

The next question comes from the line of Bill Crow with Raymond James. Please proceed with your question.

Bill Crow (Managing Director of Real Estate Research)

Yeah, thanks. Two quick questions. First of all, on the economy, I'm wondering if you're seeing any changes to your watch list among your tenants or any sectors in particular that are starting to show weakness? The second question is really, in order to get the kind of 9% ROE returns on acquisitions, do you have to target longer WALT or how do you get that if we don't see distress among current holders or owners? Thanks.

Hamid Moghadam (Chairman and CEO)

So our credit issues are fairly modest, and they usually involve retailers, and we have a built-in 85% plus mark-to-market on those leases that we've identified as potential risks. And, you know, we've actually captured some of those spreads and already improved our position by buying out those leases or just getting them back and re-leasing the space in a short period of time. So I don't think credit is a particularly important consideration in this cycle.

Tim Arndt (CFO)

And then the second question on the WALT, extended WALT being necessary for the kind of IRRs we're targeting in acquisitions.

Hamid Moghadam (Chairman and CEO)

We're using the same lease terms and acquisitions than we always have been. There's not—I mean, if you look at 30 years of history, I mean, our WALTs have been between 4.5 years and 6 years or something like that on average in our leases, so it doesn't move around that much.

Tim Arndt (CFO)

Yeah, that I would just pile on there, that we look at these opportunities of whether it be one to three or four years of negative leverage as an opportunity, really. We look at total return on every deal, and again, we take it through our filters of quality, mark-to-market, and, you know, whether we want to hold it long term or not, and then we layer that on with our potential essentials revenues and synergies and otherwise. So while it's one consideration, so are all these other factors.

Operator (participant)

The next question comes from the line of Blaine Heck with Wells Fargo. Please proceed with your question.

Blaine Heck (Executive Director and Senior Equity Research Analyst)

Great, thanks. Just wanted to follow up on guidance. You touched on this a little bit. The guidance implies a decrease in FFO in the fourth quarter. Can you just talk a little bit more specifically about some of the moving pieces there and one-time items that are influencing the numbers in the third or fourth quarters, and whether any of that noise is going to persist into 2024?

Tim Arndt (CFO)

Yeah, to answer the last part, no, I don't expect anything into 2024. Basically, of the $0.03, a couple of pennies that were related to termination income from some leases that were canceled, and then higher interest income. There's about $0.02 there. I would call that, that's permanent to the year. And then the other penny in the quarter, I would say, is more of a timing issue, specifically in taxes. We'll see some lower taxes in the third quarter, but higher again in the fourth quarter. So if you take that with regard to the roll, if you take that $0.03 out, you're basically rolling from, let's call it $1.30 to $1.28 in the fourth quarter, is what's implied in our guidance. And, basically, you would roll NOI forward.

We're gonna probably add $0.02 from just base, same-store growth, quarter-over-quarter. And then the declines are gonna come from mainly ramping of development. We see much more investment in land and CIP starting to build. And you should be aware in your models, you know, our cost of funding development in the short term is essentially 6%. Think of that as SOFR plus our line rate. We're capping interest at our in-place debt, is how this works. That's at 3%. So in the short term, that's a drag on core FFO seen mainly in interest expense. Obviously, over the long term, the margin and value creation is there, but we will see that drag pick up as developments ramp.

Operator (participant)

The next question comes from the line of Ki Bin Kim with Truist Securities. Please proceed with your question.

Ki Bin Kim (Managing Director of US REITs Equity Research)

Thanks. Good morning. Two quick ones here. First, on the utilization rate that ticked down a little bit this quarter, I was wondering if you can provide any more color around that. And second, if you look at the larger development landscape and look at competitors that are developing, I would assume that the pressure for them to lease up space and maybe they have to pay back the loans to banks probably increases as we move forward. You know, I'm not sure how big these developers are or how much capital they have behind them, but is there any risk that as these developers look to secure tenants, that could drive rental rates lower going forward?

Chris Caton (SVP, Managing Director, and Global Head of Strategy and Analytics)

Hey, Ki Bin, I'll take the utilization question. Thanks for it. As you see on the page in supplemental, there are multiple metrics on the page, and we look at all of them in totality and additional ones that are not included in the supplemental. So we have a range of proprietary data, whether it's our IBI survey, tenants in the market, customer decision-making time frames, or sales pipeline. Specific to the utilization data, that lags, that does not lead economic and real estate cycles. We've seen that over time. And so what I think this is best understood in the context of today's retail sales numbers, which shows a resilient consumer that is outperforming expectations and leading to lower utilization levels.

Hamid Moghadam (Chairman and CEO)

Yeah, on the second issue of opportunities, there are a lot of merchant developers that were bank-financed and active in the market, and they are, you know, just about completing their projects now. They have some interest reserve, obviously, built into their lease-up plans, but their lease-up plans are going to get extended. So actually, I think what's going to happen is that they can't really afford to rent the space at the lower rate. I think they're more likely to actually sell their positions to people with stronger balance sheets. And we've already seen and taken advantage of a couple of instances like this.

So don't be surprised to see us buy some vacant, completed shells at discounts to replacement costs, because, you know, it's because of our view on demand and supply, with 65% decline in supply, we think, if you get into late 2024, early 2025, we're going to be in a pretty strong market. So, this is where balance sheet matters. This is where quality of location and product matters, and we're going to be very selective about the projects that I described. But, that's why we've been building our balance sheet and keeping our leverage around 20% all this time. This is when we put it to work.

Operator (participant)

The next question comes from the line of Vince Tibone with Green Street. Please proceed with your question.

Vince Tibone (Managing Director and Head of U.S. Industrial and Mall Research)

Hi, good morning. I have a follow-up on an earlier comment about, you know, about 20% of your markets you're managing for occupancy, not pushing rent. So what, what are those markets where industrial landlords have less pricing power today?

Chris Caton (SVP, Managing Director, and Global Head of Strategy and Analytics)

Sure, Vince, we covered a couple of them. Talked about Southern California, point to Houston, Indianapolis, and then outside the U.S., the softest market might be Poland.

Hamid Moghadam (Chairman and CEO)

And China.

Chris Caton (SVP, Managing Director, and Global Head of Strategy and Analytics)

And China. And I think, I'd offer, now that market vacancies are beginning to gap out again, I think we're going to see quality make a bigger difference in terms of portfolio mix.

Operator (participant)

The next question comes from the line of Vikram Malhotra with Mizuho. Please proceed with your question.

Vikram Malhotra (Managing Director, Senior Equity Research Analyst, and Co-Head of US REITs Research)

Just wanted to get your thoughts to just clarify one thing more broadly. You know, two trends, I guess. One, just the whole reshoring theme that, you know, we're hearing more and more about. And then second, just Amazon, as you know, they've put a lot of capital into the coast and across the country. I'm just wondering, sort of, when you marry those two things together, is there, you know, sort of greater investment kind of moving towards the Midwest or more manufacturing pockets? Is that sort of an opportunity for, you know, PLD going forward?

Hamid Moghadam (Chairman and CEO)

So, generally speaking, I would say on where manufacturing is taking place, in Asia, there's a lot of manufacturing still in Asia. It's not all in China, and it had been gradually declining in China in the last couple of years anyway. It was first moving to western China, and then it was spreading to other places in Southeast Asia. But there are going to be strong flows still from those places. It's just not going to be all from China. But the container doesn't care whether it's coming from, you know, somewhere else, or China. It lands in the same ports. Secondly, demand in our product is mostly driven by consumption and not manufacturing. In manufacturing, the finished product ends up in a container and on a truck or a ship.

So the warehouse is a truck or a ship, so the manufacturing per se doesn't generate a lot of demand. When those containers land in places where consumption takes place, that's when the demand is generated for deconsolidation. Now, those markets happen to be in populous parts of the country, because that's where the consumption is, and those markets tend to be high barrier to entry markets. So we don't think the dynamic of onshoring to the extent that it exists is going to change things around all that much. The biggest beneficiary of onshoring has been actually nearshoring, and it's been in Northern Mexico. Northern Mexico markets are 100% occupied, and there's insatiable demand for product in those markets, and most of that is basically distribution buildings that are used for manufacturing purposes.

So that's where we've seen the material demand. If there's more demand coming for manufacturing in the U.S., we haven't really seen it, and if we do see it, we'll be the beneficiary of it, because we're well positioned in those central markets as well.

Operator (participant)

Our last question comes from the line of Blaine Heck with Wells Fargo. Please proceed with your question.

Blaine Heck (Executive Director and Senior Equity Research Analyst)

Great, thanks. Hamid, just a bigger picture question for you. Can you talk about how you're thinking about managing exposure to geopolitical risk and, and instability, and maybe to what extent the latest turmoil in the, in the Middle East could impact your operations, if at all?

Hamid Moghadam (Chairman and CEO)

Yeah, I think the effect is gonna be indirect because, you know, the Middle East is not obviously a source of product or exports, or we're not active in any of those markets. So it will be a second order effect on the macroeconomy. And, you know, if the Fed remains very aggressive on rates, if you believe their talk, and all of a sudden we have some drop-off in demand because people... That conflict expands and, you know, the nightmare scenario would be that, you know, a couple of tankers get sunk in the Persian Gulf at the narrow end, and oil goes to $200 a barrel. I mean, you know, the bets are off. But boy, if we see that scenario, I can't think of a better business to wanna be in.

I hate to see that scenario happen, but actually, on a relative basis, it should be good for our business because it will mean that people will—First of all, inventory becomes really important, and it means that it's yet one more uncertainty, like the pandemic, like the earthquake, like all these other disruptions that we've seen, that will push the general posture of companies from just in time to just in case. So I hate to say it would be good because it's an awful situation that's going there, and before this is all over, a lot of innocent people are gonna get killed, and I don't wanna see this happen, but I don't think its impact on the business, on a relative basis, is gonna be terrible.

I'm honestly more worried about the Fed overdoing it than that conflict escalating. But, you know, those things are very hard to predict. I think that was our last question, so we really appreciate your participation. Really look forward to seeing all of you at our upcoming Investor Day, and I promise it will be really good. So take care.

Operator (participant)

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.