Duck Creek Technologies, Inc.
Q2 2017 Earnings Call Transcript

Published: 4 Aug 2017

[Operator:]

Good day and welcome to the DCT Industrial Second Quarter 2017 Earnings Conference Call. All participants will be in listen-only mode [Operator Instructions]. After today’s presentation, there will be an opportunity to ask questions [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Melissa Sachs, Vice President of Corporate Communications and Investor Relations. Please go ahead.

[Melissa Sachs:]

Thanks, Nicole. Hello everyone, and thank you for joining DCT Industrial Trust’s second quarter 2017 earnings call. Today’s call will be led by Phil Hawkins, our President and Chief Executive Officer and Matt Murphy, our Chief Financial Officer, who will provide details on the quarter's results and update to our guidance. Additionally, Bud Pharris, Managing Director of DCTs West Region will be available to answer questions about the market, developments and other real estate activities. Before I turn the call over to Phil, I would like to remind everyone that management’s remarks on today’s call will include forward-looking statements within the meaning of federal securities laws. This includes, without limitation, statements regarding projections, plans or future expectations. Actual results may differ materially from those described in the forward-looking statements, and will be affected by a variety of risks, including those set forth in our earnings release and in our Form 10-K filed with the SEC, as updated by our quarterly reports on Form 10-Q. Additionally, on this conference call, we refer to certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures are available on our supplemental, which can be found in the Investor Relations section of our site, dctindustrial.com. And now, I will turn the call over to Phil.

[Phil Hawkins:]

Good morning, everyone and thanks for joining our call today. The second quarter reflected continued momentum in our business, driven by healthy demand, low market vacancies and rational levels of new supply. This translates into a better than expected rental rate and NOI growth than we projected at the start of the year. Our results to-date, along with our confidence in our market fundamentals, led us to increase our operating and FFO guidance for the year, which Matt will review in more detail shortly. Owners and developers continue to display a high level of discipline and patience in leasing risk base staying much more focused on achieving or exceeding the desired rents in our occupancy in lease up. And similarly, tenants remain much more focused on finding the right building in locations than on rents. That isn’t to say, however, that they don’t care about cost, but tenants and their brokers do understand the market. And after a fair amount of the usual negotiation of a pair to pay market rental rate for the building they want rather than switching to a lower cost alternative, it doesn’t meet their quality or location needs. With low market vacancy and continued active tenant demand, I expect this favorable leasing and rental rate environment to continue for quite some time. Reflecting the strong market, leasing in our development projects continues to go very well with our current pipeline now 42% leased, up from 31% last quarter. For comparison purposes, the same pool of development assets from last quarter is now 48% leased, up from 31%. We have several additional leases now in negotiation with good proposal activity across all of our development projects. And while we have been fortunate in leasing up our projects faster than 12 months, we continue to believe that projecting a 12 month average lease up going forward is prudent given that we are more focused on rent and tenant quality than speed of lease up. The current development pipeline has a projected stabilized yield of 7.4% and an average estimated value creation margin of 45%, representing a very attractive risk adjusted return on capital and substantial value creation potential. Lastly, a quick comment on dispositions. A combination of successful leasing at projects that we have identified for sale, combined with a continued healthy sales market, led us to increase our disposition guidance for the year. While our relatively small dollar amount, we do expect to exit the little of our market this quarter. We recently sold the three buildings in this market that we held in a joint venture and are now under contract with the buyers deposit money non-refundable on the one building in Louisville that we own outright with closing expected in the next few weeks. We continue to believe that this is an excellent time to sell our lower growth assets, so we can redeploy that capital into development, which offers higher growth and value creation potential overtime. With that, I’ll turn the call over to Matt.

[Matt Murphy:]

Thanks, Phil and good morning, everyone. Current market conditions are steady healthy demand combined with historically low vacancy continued to create an environment of positive surprises in rental rates and occupancy that are translating into very strong financial results at DCT. I will go through some of the details of our second quarter results, and walk through our guidance for the remainder of the year. Today’s positive market dynamic is very evident in our leasing statistics for the second quarter where DCT’s rent growth of 40.2% on a straight-line basis and 17.8% on a cash basis represents the best result in our Company’s history. For the past four quarters, rent growth on new and renewed leases has averaged 26.5% on straight-line basis and 11.2% on a cash basis, both well ahead of our expectations. This prolonged improvement in market rent has and will continue to help drive excellent organic NOI growth in our portfolio. NOI growth for the second quarter in our annual same-store portfolio was 9.3% on a cash basis and 3.9% on a straight-line basis. While the cash number was enhanced by the decline of $2.8 million of free rent quarter-over-quarter, cash same-store NOI growth would have been approximately 5% without the free rent burn off, driven primarily rent bumps and positive re-leasing spreads. It’s worth noting that this growth was achieved with static average occupancy and despite a decline in miscellaneous income. It’s also worth noting that our definition of same-store properties only includes development and redevelopment assets that were fully stabilized throughout both periods reported. Before I move on to guidance, I wanted to point out one other item in our same-store numbers that wouldn’t be readily apparent when looking at the financial statements for supplemental. In the second quarter, we received several final property tax build related to prior years, whether because of appeals being finalized or because of certain jurisdictions that build significantly in rears. These builds were meaningfully lower than the approvals we have previously recorded for these buildings. As a result, we decreased property tax expense in the quarter by approximately $1.5 million and correspondingly decreased recovery revenue by about $1.4 million, as the majority of the savings belongs to our tenants. While this obviously has very little impact on the bottom-line, it did effect the year-over-year growth in each line item. Including this adjustment, our annual same-store portfolio shows a quarter-over-quarter decline in rental expenses of 2.5%. Excluding this true up, expenses would have increased a more intuitive 4.5%. Turning to guidance, we are narrowing and increasing our 2017 FFO guidance as adjusted to $2.39 to $2.45 per share, an increase of $0.02 per share at the mid-point. This increase is predominately related to operating performance for both our second quarter results and outlook for the remainder of the year improved. The underlying elements and assumptions of our guidance are as follows. We are narrowing and increasing our expectations for 2017 average operating occupancy to between 97% and 97.75%, an increase of 38 basis points at the mid-point. This increase is a result of both fastest lease-up of vacant spaces as well as better tenant retention, the combination of higher than expected occupancy and higher rents that’s caused us to narrow and increase our same-store NOI projection for the year. We are now anticipating increases of between 7.25% and 8% on a cash basis and between 3.75% and 4.5% on straight-line basis, increases at the mid-point of 63 and 38 basis points respectively. As always, our occupancy and same-store NOI guidance do not contemplate the potential impact of any future acquisitions or dispositions. We are increasing and narrowing our guidance on development starts to between $275 million and $350 million with the majority of the remaining starts expected to occur in the third quarter. We are also increasing and narrowing our guidance to between and $50 million and $100 million, our acquisition guidance to between $50 million and $100 million as we closed down or identified a few transactions in the past 90 days. While the amount is probably not significant, we believe each of the transactions will enhance our portfolio and cash flow growth potential. Our disposition guidance is increasing to between $150 million and $250 million, the remaining expected dispositions for the year likely will be back end weighted with the bulk occurring in the fourth quarter a bit later than our earlier projections. In summary, the second quarter has continued the narrative of the past several years with the fundamentals of our business remain very strong and our execution continues to surpass expectations. As a result, our financial results and expectations continue to be very positive as well. With that, I'll turn it over to Nicole for questions. Thank you.

[Operator:]

Thank you. We will now begin the question-and-answer session [Operator Instructions]. Our first question comes from Manny Korchman of Citi. Please go ahead.

[Manny Korchman:]

So may be one for you. Are you more surprised that you're able to keep retention as high as you can, or that you're able to push rents as hard as you can?

[Phil Hawkins:]

Both high class problems to talk about, I think they’re both related. We're in an environment where the quality of the building location matters, tenants are leaving not because of rent but because of the building along that meets their needs, most likely it's not big enough, but the space isn’t big enough. And that same environment allows us to push rents. As I said, tenants don’t care about rent that would be an injustice to the process and to the effort of our market teams. But it's clear that everyone is putting a lot more emphasis on function, whether that’d be a building function or location function or both than they are an actual cost, but totally related. So I think that the answer is the same is they both are reflective of the current environment we’re in.

[Manny Korchman:]

And then may be just thinking to tenants and sort of physiology for a second. How many of them, when you present them the bigger rent-check the new lease, start to think more about the way that they’re doing their business, whether is the space big enough, or it is too big? Can we have -- do we need a location that has more people or less people, or do we need more truck base or less? How many of them making that decision and how many of them saying, our business is healthy, it's another three or four, or five year renewal, let's just sign and move on and we’ll deal with this when we get there.

[Phil Hawkins:]

I think it's the reverse. Tenants giving a lot -- the tenants we deal with primarily are in this business, selling office building where a loss of deals with lease once every five or 10 years, and really not in a business of leasing space. Most of the tenants we deal with are professional tenants in our buildings and what we do are an integral part of what they do. And so they’ve been thinking this through a very sophisticated way most often, way before they get to us. Clearly, we have a dialog hopefully its ongoing and regular drop the whole lease. But by the time they get to us other than again normal posturing and negotiation was clearly comes on. They’re not going to showing every card nor are we on the first formal meeting related to a lease. But I think that that is to me the tenants are very thought through what they need and they made a decision. More and more of decisions had have been for a while in a long term, and not just kicking the can on the road, which is good for us, good for everybody. You get a few -- you get some of that. It's kind of renewals where it's easy to renew for a year or two or three, because you're already in the space. But again, it's a pretty involved and thorough process.

[Operator:]

Our next question comes from John Guinee of Stifel. Please go ahead.

[John Guinee:]

Question, in the last 12 months, if you think about development cost in your various markets, primarily a land or land to get it fully entitled and then also generic card cost. How have they moved? If you can give us a little bit of a insight on that.

[Phil Hawkins:]

Yes, I think basic cost up 5% comprised of material cost and maybe up a little bit less than that. Labor cost more than that and then contractor margins more than that. I mean contractors are now prioritizing and being more selective and also pushing their own prices, don't blame them. And there's also some capacity challenges, for example, in Chicago precast where you're not tilting and putting in place and tilting, you're bringing in precast. There's a nine to 12 month backlog. And then the other thing that's gone up and there's also taking longer is entitlement, the entitlement approval process outside fees are going up, the entitlement costs are going up. And then just the time it takes to get them done, which has a cost because of the current value of money is also gone up. I think it all rounds up to probably about 5% higher today than it was a year ago, excluding land and that was a key part of your questions and that's time of course where market specific and higher generic. Obviously land costs are up at least that much on average across the country, some probably closer to 10%, but many of them in the 4% to 5%, 6% range.

[John Guinee:]

And then second question, in terms of turnover cost per square foot. It looks like you’ve been holding pretty steady at $2 to $2.50 per lease year. What's your thought on providing turnkey TI dollars for these tenants? Or are they putting money into the space? We know this in the retail world and the office world that more and more of the landlords are essentially financing these businesses. But how's that working in your business?

[Phil Hawkins:]

It's a combination. Clearly, the tenants are doing more to their space than they were 10 years ago, or five years ago. So the total costs are up. We continue to remain -- willing to fund without generic improvements, typical improvements. The costs are always just like construction costs are up a little bit. And then tenants are then investing more money in their space than that. We also are willing though for the right credit to fund, but amortize over the term of that lease, some of those costs. And that -- usually the rate we’re getting return is 7% to 10% interest rate on top of full amortization of the principal. But I view it as a negotiation. And what’s more important -- if it's more important to them than to us and capital is something we care about, but we certainly have -- if we’re getting the right return on it, happy to provide it as long as the return we're getting back is attractive. And then re-portion what’s important to us, which is rental rate and rent bumps. I’d much rather deal with rent bumps and rental rates and then be less difficult when it comes to a discussion on improvements.

[Matt Murphy:]

The only thing I’d add to that the way I heard your question anyway you were talking about maintaining a line between $2 and $3 that you said for year of term that’s total $2 per square foot on the leases that are signed as opposed to per year term.

[John Guinee:]

Last question, you got a big package out there in the market. Are you allowed to talk about that?

[Phil Hawkins:]

We’re allowed, but I don’t want the jinx the situation. We are out with couple of different packages; one, clearly large one Eastern, Southeast type of package that we hope will be as well received as we think it will be, high quality class A assets with long duration leases in place with credit tenants, we’ll find out we’re price sensitive. We’ve got some other packages on market, the one you’re talking about is we want and tenant to do that originally and through to the package. But the belief is that may be the potential for a portfolio of premium. And if we can get that we’ll be thrilled and sold as one package but we’ll also be want to break it up if execution and pricing make sense to do it that way.

[Operator:]

Our next question comes from Jamie Feldman of Bank of America Merrill Lynch. Please go ahead.

[James Feldman:]

So it sounds like you were surprised to the upside on rent growth this quarter. Any read-through for it means for leasing spreads as you look ahead to 2018, and your mark-to-market?

[Phil Hawkins:]

Jamie, I think the answer is, I don’t know for sure. What I will say is that I’ve talked for probably a year or maybe more about trough leases and knowing that our comparisons, the leases that we’re comparing against were in many cases right now done in the lowest, what I call trough, which is 2009 through 2011. And clearly this quarter’s numbers have been enhanced by that. I think to me what’s encouraging about this is that the ones that are after the trough, if you will, still had 20% plus rental rate growth on a straight land basis, and was just under 10% on a cash basis, which to me is more indicative. So now we’re talking about what the algebra looks like after the recession mudding up the waters. So I think there is a read through. I’m always reluctant to extrapolate rent growth numbers, because they are so dynamic it's why we’ve never given out short-term guidance on them. But I think the basic fundamentals of that are remarkably encouraging.

[James Feldman:]

And then just one more, some of your peers have talked about improved outlook for the supply -- for supplier risk across their markets. Could you say in the last quarter or so things have changed in your mind also?

[Phil Hawkins:]

No, I had a more balanced perspective last quarter than some I am still where I am. There is plenty of capital out there, it’s all equity very little non-recourse debt. With respect to the construction, developers bring discipline for a long time for a variety of different reasons that are structural, not just based on long-term memory, which we know they don’t have. There is plenty of supply in all of our markets, some more little bit more than you like, but it’s in an environment with low current vacancy rates and where the quality of the building matters a lot. And as we go, I think we’re in the same environment we’re in last quarter.

[Operator:]

Our next question comes from Craig Mailman of KeyBanc Capital Markets. Please go ahead.

[Craig Mailman:]

Matt, maybe starting with you. Just looking at same-store guidance, it continues to be strong and move higher here, but it’s probably at a level that maybe isn’t sustainable into ’18. And it’s always interesting that you’ve got the 5% gross debt without free rent. I guess maybe if you have a number on hand maybe a good baseline comparison as we head into next year. What would that number be on the full year guidance? And maybe even if you have it on ’16 to get a trend of where under that core cash answer would ex some of the non-cash noise?

[Matt Murphy:]

The every present desire to get ’18 guidance. I think, well one, you bring up in your question, the primary point that I would make, which is that absent. So for the last two quarters we’ve effectively been flat on an occupancy perspective. And I’ve tried to be real clear on stripping out the impact of the burn off of free rent, and it’s the year-over-year burn off of free rent is the comparison. And in each of the last two quarters, the answer has been right about 5%. I think I’ve talked a number of times about how our average bumps in the portfolio are about 3%. The actual mathematical, the factual answer to that, is our average next bump is more than 3%, that’s built-up of some factors that are -- they’re not really teaser rates any more, sometime it’s staggered lease-up, sometimes it's leases that don’t actually bump every year. So it’s becoming far more prevalent that bumps are 3%. And so if you assume static occupancy then it becomes an analysis of both where re-pleasing spreads will be and other beneficial impacts that I’ve also talked about in the past of just being in a prolonged landlord friendly market, you win more throws in terms of negotiating your ability to recover expenses all that sort of thing. So I probably answered longer than I needed to, because I don’t really want to try and set the bar for 2018, right now. But I think what I’ve talked about is that we are now four quarters in a row sitting around 5% without the benefits of any of these extraneous items, if you will. And I think to me the most significant part about that is that I think generally people, I’ve seen models I read before, I think people have the near term numbers pretty accurate. There are some that are higher than others there are some that are lower than others, when I say higher and lower, I really mean that me. But I think what’s maybe missing is the acknowledgment or belief, if you will, that we have experienced the paradigm shift in the longer term growth rates for industrial. This isn’t your father’s industrial financial environment that I think the longer term rates, because of all the factors we’re talking about are maybe more positive than I think some people perhaps are giving credit to as they think through what the future looks like. It’s not a guarantee. We don’t know that the economic environment is going to remain as it is, who knows. But I think the assumptions inherent in many people’s reports and models, is that it will be because how you predict otherwise. And yet, I think the growth maybe -- I think it’s I feel like and buy it for sure. But I feel like the basis fundamentals are different.

[Craig Mailman:]

No, that’s helpful. I wasn’t searching for ’18 guidance, I was just trying to…

[Matt Murphy:]

You’re doing your job, I am doing mine…

[Craig Mailman:]

No, I was just trying to set the stage and read through the optics and going from high 7s to something lower next year, and kind of making buffering the concern, I guess, of deceleration?

[Matt Murphy:]

And I'm just pulling your leg, as you know.

[Craig Mailman:]

Separately, may be for Phil. I guess, we're all talking about infill and the demand there and the growth there, and I guess maybe this is the two-part. But just curious across may be some coastal to market and some non-coastal where you're more infill; one, are you seeing ring of infill migrate out towards something what you would consider non-infill assets now become infill as guy just can't get in there; and two, if you're not seeing that and the demand continues to chase the same small subset of assets. I know we’re all talking about rent growth going up. But I mean a lot of this is e-commerce driven. Do you see that net gap narrow between what retail rents are at strips and maybe some malls versus what you guys have the ability to charge for industrial?

[Phil Hawkins:]

I can't answer the last question, because I have no idea of what our rents are in shared malls, either a year ago or today, and I am not building a mall, I'm not going to shop for a long side. So I am the wrong guy to ask that question too. I think we just see they’ve got their call right now, and jump over there. It's too simple, to simply bifurcate the world with infill and non-infill. So I think to me I would rather own and then operate and develop more infill sites and sites that are more infill than not infill period. But you're also seeing and so the non-coastal markets, particularly actually even in local market, Inland Empire East is a good example. While we talk a lot about the importance of infill and that’s where the demand is, obviously, tenants that are going further out for whatever reason that could be that location could be better or it could be that they are more rent sensitive in their business model than others. And in this environment rising tide is lifting all the boats. I think some boats are going a little faster than other, and I hope we're one of those boats, because of our strategy but only time will tell. I think the real key to me about infill is I think it’s a more sustainable business model as an investor, operator and developer than it is just simply meeting demand. When the tide first going out, I’d much rather own a building whose location makes it a lot more durable, because of value creation and demand depth than further out South Dales or Inland Empire East or Central Pennsylvania, or whatever south or part of West Chicago. I mean every market got, every major market has their examples. I’d rather stay away from that.

[Operator:]

Our next question comes from Eric Frankel of Green Street Advisors. Please go ahead.

[Eric Frankel:]

I certainly appreciate that occupancy can’t get much -- can't move much higher, but wanted to address Chicago again from last call. I think you knocked out a lot of your lease maturities that look pretty high last quarter, but they’re not that this quarter. But the occupancy -- the market occupancy still looks somewhat low-ish may be you can talk about some of the space you need to fill their.

[Phil Hawkins:]

Eric, I think it is. It’s the nature of beast sometimes that expirations clump and that’s clearly what happened in 2016 and ‘17, really more early '17. I think we've done a lot of shorter term leasing in Chicago that has -- so in other words, you get expirations more frequently. I think what I continue to see in Chicago is there is very good leasing velocity, and we have for an 18 month period, both leased a lot of space and had a lot of space vacated. And therefore, have kept our occupancy more or less where it is. We still have a couple of spaces. We have a couple of hundred thousand square feet that has -- it’s both in our expirations as of June for the remainder of the year. We've now signed it through the end of the year. So we both leased it and still have to lease it again. Now it maybe that tenant turns into a long term and so it may not be. So we're trading water, we're doing a lot of leasing. There's actually been pretty rent growth. One of the best rent growth stories we had in our second quarter numbers was a space pad in Chicago. In that case, it was both a representation of the market getting better, and it was frankly pretty tough lease that we had to sign, that one was in 2009. So there's work to do there. The good news is there's a lot of demand and a lot of activity. But obviously, it's a big market whose average is below the portfolio average. I think a lot of that is, as I mentioned off the top, just the function that we had a lot that expired at the same time. Probably not in our best buildings, which you know I'd love to say that all of our buildings are our best buildings, that's obviously impossible. And so we keep making progress.

[Eric Frankel:]

I'll probably just jump back in the queue. But Phil maybe just a broader question. Do you think your development guidance this year, how sustainable is that do you think in the next few years? Do you think that that can actually rent up higher given your platform and your personnel in place? Or is it just that or is it really tough to increase it much more based on the current competitive landscape?

[Phil Hawkins:]

Well, some of the markets so I can tell our accrual process going through in this space; could we ramp it up little more, probably; or is that likely, probably not. It just takes, for two reasons, one is we need a lease and it takes time to lease. You got to build it and lease it and we're not going to get too far ahead of ourselves in terms of un-leased capacity we track very closely. The un-leased percent of our -- development, the value of our un-leased development, as a percent of total assets and don't want to exceed 10%, which means we can move a little bit higher but not a lot. And then second, we are only focused on sites that we like really long term, more infill, more difficult to develop, problems as a result need to be solved. And I'll give you an example real quickly, hopefully quickly. We're working on a project on East Coast, zoned from day one correctly. And we are now 18 months into the accrual process and with trying to convince neighbors and what not to sign-off. We'll get there, we think. But it's not -- even when it's zoned right, it's taking us 18 months to get it through the process and won't have the final hearing, hopefully the final hearing until mid-September, so it's not getting easier and therefore, it’s not getting any quicker.

[Operator:]

Our next question comes from Rob Simone of Evercore ISI. Please go ahead.

[Rob Simone:]

Matt I'm going to ask another version of earlier question, so go easy on me. But so if you think about the pretty wide spread between GAAP and cash like everyone knows that obviously they should converge overtime. But if I think about where your average rents are today and those 3% bumps. What’s the lead time to those numbers eventually converging? And then I guess my follow up is, if you guys have had four quarters of call it plus or minus 5% same-store cash NOI without the one-time effects. Why hasn’t the GAAP number come up to that?

[Phil Hawkins:]

I think if you think about -- so I first where my mind goes my start is, it's a five year business, right. So it’s all else being equal, you would think. So what’s really happened is you’ve seen occupancy increase overall. Occupancy increases are always associated with and connected with free rent periods it's just the way our business works. And bumps have improved overtime. So if you assume a change happen to all it once, you would think those numbers would converge after five years, because our five year businesses -- it’s a five year lease business. What’s happening is obviously the past say static and the new leases continue to be dynamic. So what happens is it’s not like we went from 1% bumps to 3% bumps overtime. What’s happened is it’s become more and more relevant. So if you assume then it was a three year process, you work your way through to it. So I think the fact of the matter is rents are getting better at an increasing pace and bumps are getting better than increasing pace. So you’re right, overtime, by definition GAAP and cash they are equal, because you’re talking about the same revenue stream. And what makes it hard to answer that question in the real dynamic world is that things are moving, both the comparisons have moved over their five year period and the new leases are moving over their five year period. I think the biggest thing is we’re now to the point where occupancy is static and therefore free rents is more likely to be static. And so I think you see those numbers really start to converge, really starting now. I’ve said this before that the back half and I think I was answering your question before. The back half of the year free rent differentials is effectively zip. And so that element will go away on a quarterly basis, almost effective immediately on an annual basis, it will really start to manifest itself in ‘18. But I hope in a rising tide, cash will always continue to outpace it in the short-term, because of all the things that I mentioned, bumps are getting better, rents are getting better, and the path remains static. So you have to stop the music for them to actually converge and hopefully, the music doesn’t stop.

[Rob Simone:]

And then the second part, just the GAAP number, or the straight line numbers that you guys provide, that short of the side, plus or minus 5% level. Is that the same effect just on the option side, or how does that work? Why hasn’t that come up to 5%?

[Matt Murphy:]

I do think it’s the same thing. I haven’t really thought about it that way, and I’m reluctant to just fire from the hip. But I think that’s right. I don’t know why it would be any different. It’s just the matter of timing. And those increases get impacted sooner and therefore less pronounced. But ultimately, you end up in the same place.

[Operator:]

Our next question comes from Bill Crow of Raymond James. Please go ahead.

[Bill Crow:]

This is probably goes in the category, looking for the problems, when none-exists. But any tenants that might be still their decision making process because of global exposure or NAFTA perspective changes, anything like that.

[Phil Hawkins:]

I don’t think we have that kind of insight. I’d say the answer to your question is no. I would say for development properties, tenant decision-making, if it was speed was white-hot six months ago, it’s simply hot today. Meaning, it takes a little bit longer to get to the lease approval process, signing leases, but they’re methodical, the approval process it seems to be taking a few weeks longer. I don’t think that’s related to any global event. I think it’s the fact that they’re getting ahead of their business. We’re talking about development properties. They’ve got time, we’ve got time, and it’s being used to some extent in the negotiation process.

[Bill Crow:]

And my second question is. You talked about the approval process from the cities getting permitting, any market that are at their breaking point from an industrial development perspective?

[Phil Hawkins:]

Well, breaking point from staffing, most are understaffed. From a willingness perspective, I think that nothing is changed. If it’s already zoned, we’re in pretty good shape, if it’s not the zoned, we got a problem. They’d rather not have our businesses not in my backyard in that category. That’s not to say that we’re not trying some cases. But I’d say it remains a capacity challenge. And it requires public discussion and approvals, which therefore involves homeowners and resident and voters, it's a pretty steep uphill climb.

[Operator:]

[Operator Instructions] Our next question comes from Rich Anderson of Mizuho. Please go ahead.

[Rich Anderson:]

So couple of weeks ago, Duke reported and said that the business is operating in a state of equilibrium, which isn’t a bad thing, considering the high level of occupancy. I’m just trying to pick through the things that you said today. Do you agree with that statement in your markets, or do you still feel it’s not quite at equilibrium and you’re undersupplied still given your comments?

[Phil Hawkins:]

Well, for the last several quarters, maybe last year or two a number of people on the sales side, as well as the buy side and as well as the management teams somehow are infatuated with this concept of equilibrium. We’ve proven and we don’t know how to project it, but also don’t believe it’s all that relevant. I think it’s not a two variable equation, supply and demand. You got to throw in a current vacancy rates. And then you’ve got throw in a fourth subject variable, motivation of developers and owners. And the motivation, as I said in my opening remarks long-term, vacancy rates are low in every market. And as supply has ramped up appropriately so we certainly not doing it, how can we fall for others for doing what we’re trying to do. And then demand remains broad and deep across markets and across industry verticals. To me all four of those things need to be discussed at the same time. And not just simplifying it into are we in equilibrium or not, in our markets we think of development supply, not pre-leased supply compared to trailing 12 months of demand. Theoretically, the period is 12 months or less of supply coming or not. And in every single one of our markets, the answer is it is below 12 month. So that mean we're in equilibrium, no I think we’re short of it. But again I think it's in almost, is that the right complete concept to think about. I know other disagree and that’s fine. But my view is it's a more complicated discussion to get at the real objective, which is the real question, how our landlords doing with rents, that’s what we all want to know. And the answer is we're doing just fine.

[Rich Anderson:]

The other thing that could screw up the story and again from falling from bills page and trying to find something that’s not wrong. Is Amazon taking over the world? Is there any -- it's not a big part of your business, but it is the largest part of your business. I'm just curious if there is any reactance at all to do another deal with them, not to turn myself into an Amazon analyst, but relatively thin margin business. Do you have any concern at all about the next five years with them?

[Phil Hawkins:]

First, we're not in the build-to-suite business with them. We've have been leasing to them second generation existing space, as well as a number of several -- our first generation development projects that we expect. So frankly they’re high margin the margins are not as different than they are for any other tenant we deal with. I had to say, privately and publically, draw lines in the sand or as they say in Washington DC some red line. There is no red line in my mind about Amazon or any other tenant. I think we’ll evaluate each situation based on the merits of the opportunity, and make the decisions at time it's a high class problem to even talk about like we have a choice. I think Amazon is a phenomenal company, a phenomenal business model that is some -- a business model that I would like to stay in touch with and get closer to even, and then we do more business with them, assuming everything else makes sense to economics and terms and all that. We're happy to do more business.

[Rich Anderson:]

And then just the modeling question for Matt. So I know we've traded emails on this earlier. But the straight line rent number came down strangely, first to second quarter. Just curious what that is and how we should be thinking about the ramp of straight line going for the rest of the year?

[Matt Murphy:]

Well, as I said earlier, I wouldn’t say it came down strangely, I think it came down totally predictably as for all the reasons I've just said. We are burning through some of -- really that’s a development free rent that’s burned off is the short answer to that. So I do think, in a static occupancy without predicting future development, because that’s the wild card that could make this change, which is why I tend to talk about free rent on a same store basis, because there will -- as we lease up our development portfolio and we’ve talked about we got a number of starts coming. There will be free rents associated with that. I think honestly whether it will be more or less than it was in the past, I don’t know. The total development volume is probably a little higher. But I think what you’ll see in the operating portfolio is aesthetic occupancy, free rent, there is virtually no free rent on renewals today, there are exceptions to that but it is really, really small. I mean you’re basically down to a third of a month per year of term on operating portfolio free rent, which is the lowest that’s ever been. So I don’t know where the new free rent comes from other than development. And so the fact that it's dwindling doesn't surprise me a bit. In fact, I’d hoped to foreshadow that as we talked about the numbers in the past.

[Rich Anderson:]

So I mean I guess the entirety or most of the straight line rent adjustment is free rent based as opposed to just straight lining fixed escalators over the course of the lease. Is that the right way to think about it, and what's your view…

[Matt Murphy:]

Yes, the way that it works is the more free rent it is the sooner it goes from a positive number to negative. The total straight line adjustment is the combination of the two right it's both free rent when you're recognizing revenue when they're not paying you any cash and also contemplating the bumps in the future. So yes, you will always have a free rent component as long as there is bumps. The smaller the portion of that adjustment that is represented by free rent, the less volatile it becomes and therefore, less noticeable it becomes.

[Rich Anderson:]

So going forward, should we think that the second quarter putting aside the development free rent is a reasonable run rate?

[Matt Murphy:]

Never parsed it like that, so I am reluctant to answer. I think, theoretically, the answer got to be yes. But I haven’t split it into its two components.

[Operator:]

Our next question is a follow up from Eric Frankel of Green Street Advisors. Please go ahead.

[Eric Frankel:]

I guess one quick follow up. Given that it is difficult to and entitled to find good land and locations that you like. Can you tell me about maybe some recent experiences, or your strategy going forward and maybe re-entitling non-industrial sites for industrial use, whether they're dead balls or suburban office buildings and the like?

[Phil Hawkins:]

We’ve had conversations with a few people from the retail world, very high level, theoretical and frankly what we confirmed is that it's going to be a needle in the haystack. It's not a haystack full of opportunities and maybe one needle in there. Nothing that's moved on along enough to say that if possible or get a personal feel for how hard it is, I think it's going to be very hard. So it's hard to -- we're still focused on land that comes from a manufacturing or industrial use for the most part or it’s already zoned distribution in industrial whatever that might be. But is there anything I am missing that maybe you and I got a chance to talk and anything you would add to that question.

[Matt Murphy:]

In the Inland Empire, as an example Eric, there is a southwest industrial plan, which is a fairly new master planned area for industrials so they're taking a little more of a blighted area and creating more of an overlay. So we’ve had some good successes in finding a couple of owners that are contiguous, tying them up knowing that in-time this general plan is going to affect this area. So we've had some successes again in that Fontana Swift area. And so that's one of the things. I've also noticed that there are some situations where you've had -- where you have an opportunity to acquire a piece of land and bring it through the entitlement process. Phil mentioned earlier the challenges maybe at some of the neighborhoods or contiguous uses. And it’s a struggle but I know our market team certainly on the West Coast and we’ve experienced that gone to city council meetings and fought the fight with some pretty decent success. So I’m encouraged that we -- it’s kind of one-off deal just fighting away to find the right deal to develop in the future.

[Eric Frankel:]

And if not you maybe one of your competitors, I think they only thought I have is that with, especially of dine malls. You can buy at relatively high yields, perhaps the land basis you don’t know exactly what it's going to be in five years or 10 years time. Looks reasonable enough so much of you, you or your competitors are considering buying similar sites and then hoping in five or 10 years it works out that industrial temples?

[Phil Hawkins:]

I have a tough time before that question come in on a hypothetical topic, but I’ll do it anyway. From my perspective, I’d have a tough time supporting a deal that is not zoned for our business, and believing that we could make money even if it doesn’t go our way on industrial. Maybe we can, maybe others would do better and maybe others have a business plan or business model or mandates in their investor that allows them to do a more broader a table broader perspective with investing. I wouldn’t - the circumstances to compel me otherwise. I’d be very tough, a tough sale on why we should take on a retail land that doesn’t have an industry use or not a strong probability of an industrial use, that’s not our business. There is a plenty of ways to make money in our world and many ways to make money in real estate where we’ve -- served us well at DCT is focusing, and focusing on our strengths, keeping -- sticking to our knitting and we got to keep doing that even if we look to our side or behind, or in front of us with envy to somebody who had a broader mandate or more confidence or whatever that gives something we didn’t do. I’d rather stick to our knitting we’re doing just fine doing that.

[Eric Frankel:]

And I want to take up a lot of time if there is no other questions in the queue. I think my one last question is just given that industrial you seem to be trading at pretty good value, as well implied cap rate. I mean the premiums or whatever have you how. I understand you’re trying to sell lower growth assets. But do you have any thoughts in terms of being a little more aggressive in buying assets in markets and submarkets that you really like right now?

[Phil Hawkins:]

We are trying, I’d say, we are a little more aggressive today than we were six months ago. Our relative position doesn’t seem to have changed. We prevailed on a few that Matt mentioned in his remarks. I’d like to buy more, if we could if we love the real estate building and location, tolerate the initial return and like the growth. But to be rents on some place and/or broad market leases that roll over in a relatively near-term. We’d like to buy more if we could, it’s just not easy, which is why I guess we’re not doing ones that like our business, lot of people want to invest in industrial right now.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Phil Hawkins for any closing remarks.

[Phil Hawkins:]

Thanks everyone for joining our call today and your interest in DCT. We had another good quarter and remain intensely focused on executing our business plan and capitalizing on the opportunities in our markets to deliver results and create value. We’ll keep doing that. In the meantime, enjoy the rest of your summer and we’ll talk soon. Bye, bye.

[Operator:]

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.