Duck Creek Technologies, Inc.
Q3 2016 Earnings Call Transcript

Published: 7 Nov 2016

[Operator:]

Good morning and welcome to the DCT Industrial Third Quarter 2016 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Melissa Sachs. Please go ahead.

[Melissa Sachs:]

Thanks, Amy. Hello, everyone and thank you for joining DCT Industrial Trust’s third quarter 2016 earnings call. Today’s call will be held 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 our updated guidance. Additionally, Neil Doyle, our Managing Director of the Central Region, will be available to answer questions about the markets, development and our other real estate activities. Before I turn the call over to Phil, I’d 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 may 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 at dctindustrial.com. And now I will turn the call over to Phil.

[Phil Hawkins:]

Hey, good morning, everyone and thanks for joining our call today. We had a very strong third quarter, as both our portfolio and the leasing markets continued to outperform our initial expectations for the year. Our consolidated operating occupancy increased 60 basis points to 96.2%, straight-line rent spreads increased 16.8% and cash same-store NOI increased 9.6%. Based on these results and our confidence in the current market environment, we have increased our operating and financial guidance for the year. And Matt will go into detail on that shortly. Our board also approved an increase of $0.02 per share in our quarterly dividend, a 7% increase. Development leasing continues to track well ahead of our underwriting. We stabilized two projects in the third quarter with a projected investment of $48 million, a yield of 7.4% and an estimated value creation margin of 32%. We signed 900,000 square feet of development leases since June 30 and have excellent leasing activity on each of our development projects. Our current pipeline is now comprised of 13 projects with an expected investment of $303 million, a yield of 7.6% and is 40% leased. Our list of future projects also looks strong. In addition to land we already own, we have a number of very well-located sites under contract going through due diligence and the entitlement process. Next month will mark the 10th anniversary of DCT’s IPO, which took place on December 13, 2006. To commemorate this milestone, we are scheduled to ring the closing bell at the New York Stock Exchange on Tuesday, December 13. The time has gone by fast and much has changed at DCT since our IPO. But our company’s strategy has remained consistent since we went public. We are committed to creating value for shareholders by being the best owners, operators and developers of industrial real estate in the United States. We have built a great market-centric organization that is highly focused on building relationships, aggressively operating our portfolio and creating value through development, redevelopment and smart acquisitions. Over the past 10 years, we have completely repositioned our portfolio, selling $1.8 billion of assets, acquiring $1.9 billion and developing $1.1 billion. We have exited 13 markets to better focus our people and our capital on what we consider to be the best long-term distribution markets in the United States. As a result, 61% of our assets are new to the company since our IPO, quite a transformation and one that has produced strong operating and financial results. Looking forward, the strategic principles that have served us so well over the past 10 years will continue to guide us in the future

[Matt Murphy:]

Thanks, Phil and good morning everyone. The third quarter of 2016 was an exceptional one at DCT. Our financial results, operating metrics and investment momentum reflect a business with historically good fundamentals as well as an organization that is truly hitting on all cylinders. I will take you through some of the highlights. Funds from operations as adjusted was $0.60 per share in Q3, driven by a 60 basis point increase in operating occupancy and continued acceleration of rental rates, both of which contributed to better-than-expected same-store NOI growth. Bottom line results were also aided by a one-time $2.5 million casualty gain. However, even without the impact of the casualty gain, FFO per share would have increased by over 15% compared with 2015, as our same-store portfolio keeps producing significant growth and the development leasing we accomplished in late 2015 and early 2016 has now turned into NOI. Leasing results also continued to impress and surprise to the upside with strong numbers in terms of volume, retention, concessions and re-leasing spreads during the quarter. Rent growth on signed leases averaged 16.8% for the quarter on a straight-line basis and 5.6% on a cash basis and has averaged over 20% on a straight-line basis and 8% on a cash basis over the past 12 months. Leasing activity has been broad-based in terms of markets, size and industries. All of this leasing has pushed occupancy in our operating portfolio to an all-time high of 96.2% as of September 30. This number is better than our expectations and positions us very well for the remainder of the year. We now expect year-end occupancy in our operating portfolio to be above 96%. Same-store NOI was very strong for the quarter, posting growth of 8.8% on a straight-line basis and 9.6% on a cash basis over 2015, as a 130 basis point increase in average occupancy was augmented by $1.3 million of embedded rent bumps, rent growth on new leases of almost $1 million and a $1.2 million restoration fee. This continued improvement in occupancy and rent growth led us to increase our full year 2016 guidance to a midpoint of 5.7% on both a cash and straight-line basis. It should also be noted that our full year numbers have been influenced by the impending sale of 3 buildings in Indianapolis, which we expect to close in mid-November. The removal of these assets from the pool will improve 2016 results by approximately 40 basis points, which is now reflected in guidance. This expected future transaction had no impact on the third quarter results. Turning to capital markets, we accessed our ATM program in the third quarter, raising net proceeds of approximately $33.5 million by selling 700,000 shares at an average price of $49.12 per share. This capital will be used to effectively pre-fund a portion of our development pipeline and we will continue to evaluate the relative mix of using the ATM and dispositions to fund activities going forward. We will obviously get into much more detail around this when we lay out our 2017 guidance on our fourth quarter call in February. With respect to full year 2016 guidance, we are raising and narrowing our funds from operations guidance to $2.23 to $2.25 per fully diluted share. This increase of $0.05 per share at the midpoint is driven by the nonrecurring roughly $0.025 casualty gain I described earlier as well as third quarter and expected fourth quarter operating outperformance. Some of the key aspects of our guidance are as follows. As I mentioned earlier, same-store NOI is expected to increase between 5.4% and 5.9% for the year on both a cash and straight-line basis. This is up from previous guidance of 4.5% to 5.25% on a cash basis and 4.75% to 5.5% on a straight-line basis. This translates into predicted growth in the fourth quarter of over 7% on both a cash and straight-line basis. 2016 average operating occupancy will be between 95% and 95.75%; development starts of $225 million to $250 million, up from $175 million to $275 million last quarter; acquisitions of $75 million to $100 million; and dispositions of $120 million to $130 million. For further details, please see the guidance page in our supplemental. In closing, I would also like to comment on our upcoming 10th anniversary. As someone who is fortunate enough to have been here since the very beginning, it’s incredibly rewarding to see the transformation that has occurred over the past decade at DCT. Part of me thinks it’s hard to believe it’s been that long and part of me feels like it’s happened almost in a blink of an eye. While I’m very proud of what we’ve accomplished in the past 10 years, what’s most exciting to me is that it truly feels like we’re just getting started. With that, I will turn it over to Amy for questions. Thank you.

[Operator:]

[Operator Instructions] Our first question is from Manny Korchman at Citi.

[Manny Korchman:]

Hey, good morning guys. Matt, I would hesitate to call these things one-time items, but they are, but they keep kind of creeping up. So if we look out for the rest of ‘16 and into ‘17, is there anything that’s either expected or in process or just could come out of the woodwork that we should be at least thinking about, if not modeling?

[Matt Murphy:]

No, there aren’t anything in the future. Obviously, I am not going to get into a whole lot of detail on ‘17, but there is no identified transactions like the $1 million. And you’re right, they’re not one-time in nature, but they are intermittent. The casualty gain was clearly a one-time kind of unusual transaction. But there is nothing included in guidance at this point of a similar nature.

[Manny Korchman:]

And Phil maybe a more broader one for you. Things feel pretty good, so what do you worry about? Is it that supply could turn quickly? Is it that demand could shrink for whatever reasons? Just what keeps you up at night?

[Phil Hawkins:]

Well, both of those are something to worry about, for sure. It’s more the unpredictable. I think I said the same thing last quarter, maybe in the last several quarters in a row. We’re in a world that clearly is volatile. We are approaching an election that certainly is interesting, to say the least. And the impact that may have on demand, short-term blips or longer term, is something I think about because I don’t know how to worry – I don’t know how to do anything about it. Supply has ramped up, but it’s ramped up to rational levels. And I still am of the belief that it will remain rational. There may be other markets – there maybe some markets where it blips above kind of demand levels for a short period of time. But we have seen pretty regularly and pretty consistently that when that does happen, the market self-regulates and those construction numbers come down. So, what I really worry about then is demand. We are all building to a rearview mirror, last quarter’s demand, last year’s demand. And so far, that’s actually served us well because demand continues to outpace expectations. But there may come a day when that’s not the case. And that’s something I would worry about. By the way, I don’t see it happening. I don’t see it happening. I mean, I don’t see any signs that it’s happening. All the signs we are seeing are tenant behavior remains strong, decisive. There is a lot of depth to the demand we are seeing. As we mentioned breadth as well, it’s across all industries, sectors, size ranges. So, there is plenty of reason to feel really good, which is why there is reason to worry.

[Manny Korchman:]

And maybe, Phil, if I could follow-up on that just the way that tenants are approaching decisions, has that changed at all whether they are accelerating or putting off decisions or is it kind of just consistent?

[Phil Hawkins:]

I would say no change. It’s hard to say it’s accelerated from where it’s been over the last 6 months. But it’s certainly no indication, as we talk to our market leaders, we talk to various customers, brokers, it remains a very healthy environment that has not either accelerated or decelerated in the last 6 months from what I could see.

[Manny Korchman:]

Thank you.

[Operator:]

The next question is from John Guinee at Stifel.

[John Guinee:]

Great. You guys are making it look easy here, wow. Couple of quick comments. Looking at your predevelopment page, you have got a couple of relatively small parcels, 10 and 15 acres in Dallas and Denver, where you seem to be spending a lot of money, probably getting it pad ready. Can you talk about those development spends? And then the second thing is what’s surprising me is how you are able to still get GAAP yield on cost of greater than 7%. Do you expect that to continue given the escalating in land prices throughout the country? And then the third is the Denver market in your backyard, that’s on fire, but you guys haven’t done too much talk about Denver?

[Phil Hawkins:]

I am going to forget all three – one of those questions. I will start at the beginning. That land site in Denver, yes, we are going through entitlement approvals. We got final approvals, not going to start until we get through the winter. So, expect to start that project in March or so, could be April, depending on the weather, but everything is a go at this point. Neil, do you want to comment quickly on Dallas?

[Neil Doyle:]

Sure. We have a pad site of about 9.5 acres in the airport submarket. And that is a parcel – it’s adjacent to a couple of buildings we own already, John and we are going to break ground here probably within about 2 weeks on a 112,000 square foot building, divisible.

[Phil Hawkins:]

In general, I would say a lot of our developments, John, and others that you may have noticed are getting smaller. And the reason is I think that’s where the market opportunities are emerging. As multi-tenant building rents have moved up, they are a little – they trail behind the big bulk buildings. They’ve moved up, development opportunities are more interesting and the supply competition is less. And it’s also – that’s kind of our bread and butter, infill sites close to the airport of Dallas, Denver, so anyway. Second question was yield and I would say yields are – I would expect yield to trend down. The land prices are going up. We try to find land sites that have some problem that needs to be solved. And we are going through a lot of land sites right now, going through entitlements, going through wetlands mitigation, traffic studies. We are not taking title, but we are spending money on sites and have under control sites in a number of markets around the country that we are investing in the land development and therefore getting paid for that effort and that risk, which helps keep yields and spreads up relative to some developers that are more focused on pad-ready sites. But I would expect yields to keep coming down. As long as we keep outperforming our leasing, we will keep doing better than we have underwritten, but we don’t project that. Last question is Denver it’s a nice little market. It’s our backyard. It’s one of the strongest markets in the country for a variety of different reasons. We actually have a building under contract. I think we waived due diligence and went firm on the deposit this week and expect to – hope to close by year end. Hopefully, actually it may be even sooner than that. So I don’t expect Denver to ever be a market like a Southern California or Atlanta or Dallas or even South Florida, but it’s a nice little market and we have got a nice little niche that we have been able to build up here.

[John Guinee:]

Great. Thank you very much.

[Operator:]

The next question is from Eric Frankel, Green Street Advisors.

[Eric Frankel:]

Thank you. I just want to follow-up on the supply question from earlier. Can you specifically talk about some individual markets where supply pipelines really have picked up in response to pretty much unprecedented demand? I guess in detail that’s – well, Dallas, certainly already. Chicago and Atlanta though are two markets where supplies, has really picked up and obviously you have some developments ongoing there?

[Phil Hawkins:]

Well, the story in Dallas hasn’t changed. And to me, it’s a story of both incredibly strong demand, the highest level of net absorption in the country, and certainly tied for or near the top, if it’s not exactly at the top, and an area where there’s a fair amount of construction, both capability of development as well as land. Much of that, as you have heard and many of you know, is on the south side and also in larger boxes. That’s not the area we play in. We are focused on infill sites in North Dallas and in Northwest Dallas near the airport, as Neil just mentioned, on the one site we’re working on, we’re assembling land, multiple sellers, various whatever challenges, and it’s served us well. Frankly, as far as development projects go, Dallas development projects continue to be – experience one of the highest levels of pre-leasing in our portfolio. Atlanta is late to the game, so it’s early in recovery. Similar story to Dallas, we have seen a lot of big box construction, as you would expect. A lot of that is in markets that are pretty far out from Atlanta in terms of that supply. It’s certainly, like Dallas, something we look at closely. But again, we have a project under construction with pretty strong pre-leasing activity and feel really good about that. We have another site we are working on, have under contract that we hope to close, and frankly, already have some pre-leasing activity interest, not necessarily leasing, but certainly pre-leasing interest from various well-known users that hopefully will turn into something successful, but you never know. Neil, do you want to comment on Chicago?

[Neil Doyle:]

Sure. Eric, as you are aware, Chicago had a – it’s not a record third quarter, but it’s up there. And it’s a little over 8 million square feet of absorption. And so the question is what supply is out there. And if I just take A assets, just call it 100,000 square feet or greater, there’s roughly about 14 million feet vacant from Wisconsin down to Indiana. And if I put the under construction on top of that number, I get to about 21 million square feet of A product divisible down to 100. That’s a year’s run-rate. And so I feel we are at a pretty good meeting. I wouldn’t say it’s a great situation. I wouldn’t say it’s a concerning situation. But we are averaging a little over 20 million square feet of absorption in the last few years in Chicago. So I am pretty comfortable. I think we will see what the fourth quarter brings. The third quarter was huge. It was much larger than the first and the second. And I do think there is another sort of trend pushing that. But 50% of the absorption in the last two quarters has been either printing, packaging, manufacturing or food. And my experience tells me that those deals can take a little bit more time in – towards conclusion, just because they are a little more sophisticated buildings. So, we will see what happens here in the fourth. But so far, it’s been a pretty epic 3 years in Chicago and it seems to have gotten stronger very recently.

[Eric Frankel:]

Okay. Final question is just related to, I guess, your Cincinnati acquisition and how you like to scale your portfolio going forward. And I think it’s fair to say with your portfolio transformation that you have put greater focus on markets with larger populations. And so I want to understand that Cincinnati acquisition rationale whether you tend to grow there, especially considering you have probably done some dispositions there over the last couple of years?

[Phil Hawkins:]

Neil?

[Neil Doyle:]

Sure. Eric, you are right. We have sold significant product in Cincinnati in the last few years. And a lot of that stuff was just low growth, low quality. And I think if you and I walked through the portfolio today, it would probably be a greater percentage change than what Matt talked about earlier as far as the nation goes for DCT. So the portfolio is getting better. And it’s getting better through acquisitions like this. So I’ll just walk you through real quickly. This was an opportunistic deal in Hamilton, Ohio, 300,000 square feet, well below replacement cost. The value-add was that it was 60% leased to a credit tenant long-term. The building itself has got all the bells and whistles, plus. And when I say plus is we have got 28-foot clear, we have got ESFR, we’ve got 50x50 bay sizes. But to me, the real selling point was that we are about 22% coverage meaning this building in a mature submarket will have 2x to 3x amount of trailer parking as any competing high B building. That is our theory. And based on the activity and the showings we have had in the month since we have owned it, I believe our theory is going to prove out. And that’s going to separate us from the pack. So this is a really great buy. It’s a simple value-add. It’s a great asset in a mature submarket with some advantages that no other buildings have. And I believe that is going to be very accretive to the Cincinnati portfolio.

[Phil Hawkins:]

And Eric, if I would add, Cincinnati, like Denver, is a market we like. It’s clearly a smaller market but it has topography barriers to new supply, combined with pretty healthy demand drivers, e-commerce, manufacturing, distribution, pretty close hub to Louisville, and also DHL has a hub there. So we like Cincinnati a lot. It isn’t a dominant – like I said about Denver, it isn’t going to be probably very often on the supplemental in terms of acquisitions. But if we can find something to acquire and/or develop, and our team there is outstanding and they are doing a great job and are working on a few development ideas that may – 1 or 2 build-to-suits as well as a few other ideas. If we could find attractive compelling investment opportunities, we will pursue it.

[Eric Frankel:]

Okay, thanks. We will get back into queue.

[Operator:]

The next question is from Rob Simone at Evercore ISI.

[Rob Simone:]

Hi, guys. Good morning. Thanks for taking the question. Kind of with the spread between demand and supply widening out through this year and you guys have obviously moved your development starts guidance up and towards the higher end, I know you haven’t provided an outlook for 2017, but is there anything you can kind of share on your view of the world as it relates to starts next year and beyond?

[Phil Hawkins:]

Yes, I will reiterate what I said in my opening remarks and also maybe repeat what I said last quarter. We got a good pipeline and it’s not all that visible in terms of our financial statement because a lot of it is under contract but not closed as we work through various entitlement issues. But I feel really good about that pipeline. I feel better about the pipeline today this year than I did last year, a year ago, about our ‘16 pipeline. I have not thought about guidance. And I suspect we will not try to put ourselves in a box where we have to develop, start projects simply to meet guidance. But if I was going to take an over/under on ‘17 starts compared to ‘16 starts, I would take the over.

[Rob Simone:]

Okay, that’s really helpful. Thanks, guys.

[Operator:]

The next question is from Craig Mailman at KeyBanc Capital.

[Craig Mailman:]

Hey, guys. Just curious you and peers are kind of pushing occupancies here above 96% on more of a sustainable basis. I’m just curious on your thoughts of maybe where frictional vacancy is in your portfolio, given the big turnover you had since the IPO and kind of the push infill and kind of what you guys are seeing as you’re thinking about next year. I’m not trying to get guidance, but kind of just trying to pick your brain a little bit about how you guys are thinking about where occupancy could be sustained?

[Phil Hawkins:]

I am not sure frictional vacancy is how I think about it. But clearly, as you get into the 96s, you start to – it gets more difficult to rise from there. It’s possible, as we have seen a number of our peers hit 97%. Two things are going on as you do there. One is one or two spaces in our company can make a difference. A 400,000 foot space here, a 500,000 space there and it maybe only vacant for 6 months, but that adds up. And so it gets harder. Second thing is clearly, as our own occupancy rises and as the market occupancy is also at historical highs, we’re pushing rents and we’re less sensitive about pushing occupancy and more sensitive about pushing rents. I’m not trying to be unrealistic about it. But clearly, now is the time to be really setting rents and pushing rents and not being afraid of vacancy, of losing. And the way to push rents is you’re not afraid of losing a deal. And right now, I would say in most of our markets, maybe all of our markets, in most of our buildings, we are not afraid of losing a deal.

[Craig Mailman:]

Okay, that’s helpful. And maybe as a follow-up to kind of the pushing rent kind of theme here, just bigger picture, as your portfolios evolve, you guys are more infill, more coastal, kind of as you think about how your tenant mix has maybe changed a little bit with more Fortune 500-type companies who have real estate as a percent of their overall cost kind of much smaller relative to your small business-type tenants, how has the conversation trended with your ability to push rents and kind of the pushback you get versus their just need to get space in the place that they need to have it to fulfill their supply chains?

[Phil Hawkins:]

First, no one on their side, the customers’ side wants likes or has an easy conversation about raising rents. We just signed a new lease in Denver, and I know what it feels like, actually, as our rent moved up from probably 50%. So I know what it feels like and it’s not easy. I would say bigger tenants, what I would call professional tenants, actually are more aware of and professional about the rent environment than smaller tenants. And I actually would – I don’t know this for a fact – I suspect that smaller tenants real estate is a bigger portion of their bottom line than larger tenants. But we still are, for almost – even for major global distribution type companies, maybe other than e-commerce, full-time e-commerce companies, real estate is still third or fourth on the list. And they are well capitalized and we really are a part of the solution, not a part of the problem. We are helping them save money and/or grow their business and/or shrink the amount of time and/or and certainly involved in getting product from one source to the ultimate marketplace. So I think – I’d say I think professional tenants, larger tenants, however you want to describe them, again, no one rolls over on the conversation, but I think that they are more aware of the environment they are in, because they see it multiple times and are seeing it from multiple landlords, multiple markets. They may have lost a deal or two, but they don’t make that mistake again. There is clearly a demand for space and a need for that space that is not price-sensitive, but clearly, they are price-savvy.

[Craig Mailman:]

Yes, thank you.

[Operator:]

The next question is from Blaine Heck at Wells Fargo.

[Blaine Heck:]

Thanks. Good morning, guys. Maybe for Phil, sorry if I missed this, but can you just talk about the Southern California acquisition? It looks like a stabilized 4.3% yield, which seems uncharacteristic for you guys. Is there any sort of value-add play there or what made that purchase attractive to you guys?

[Phil Hawkins:]

Yes, over time, the rents are substantially below market. It’s in a submarket where we own a number of buildings just nearby. And so we know the market. We have – not critical mass is certainly a word that comes into mind. So we like the market, submarket. We like those buildings. They are very similar to what we already own. And we’re pretty confident in rent growth. It will take us a couple of years to get to it, but within a couple of years, those leases will be rolling over with good quality tenants and a pretty good chance of renewal. But also even if not a renewal, we would like that space. So the opportunity to grow rent over time over the next 3 to 5 years is what really brought us to that, along with just a confidence in that submarket.

[Blaine Heck:]

Okay, got it. And then in looking through some of the leases you guys achieved on the development properties, it struck me that there were a lot of partial building leases, none that were full building. And I think you had talked a little bit about multi-tenant rents moving up. So, is that a conscious effort for you guys, building more warehouses designed for multi-tenant use at this point? And I guess how do the cost between constructing for multi-tenant versus single tenant compare?

[Phil Hawkins:]

I think, well first, every building we have built since I’ve been here has been designed to be multi-tenant. The larger buildings that we are building certainly ended up going mostly – in many cases, single tenant. But even in larger buildings, like Seattle, our White River project, the Chicago, our I-55 project of a couple of years ago, we multi-tenanted. What we are building now tends to be 100,000 to 250,000 foot buildings with obviously some exceptions on both sides of that range. And they are more likely to be multi-tenant even in a 600 to 1,000 to 1 million foot building and that’s exactly what we are seeing. That’s where the sweet spot of the market is right now. It’s the sweet spot of the submarkets we are building in. Dallas is a good example, as Neil already talked about. The buildings we have down there are leasing multi-tenant. We expected that. It’s where the market is right now from what we can tell. But we are happy, if somebody shows up and wants the whole building – and by the way, there are a few examples that I can think of right now of leases pending or being worked on that are single tenant leases. So, we are happy to do it. Economically, the rents tend to about offset. We are almost indifferent. You have a little bit more cost to subdivide the building, but you also tend to have little bit higher rents as well.

[Blaine Heck:]

Okay, that’s helpful. And if I can sneak one more in, can you talk about your outlook for Houston, still one of your largest market concentrations with about 9% of your annualized rents coming there. I guess what’s your updated view on the market at this point? Do you think you are happy with the rest of the properties there? Should we expect to kind of – the exposure to continue to come down in the future?

[Phil Hawkins:]

Neil, you want to handle that one?

[Neil Doyle:]

Sure. So Blaine, earlier in the year, we did sell some of our higher finished assets. And there’s no more planned at this point in time. We have got – if you are looking at what’s happening down in Houston, you have got really a tale of two cities, really based on oil pricing at the moment. Some of the higher finished buildings, North and Northwest, have suffered a bit with oil and gas companies pulling back. The flipside is that 8 of the 10 top deals done in the third quarter have been down in the southeast port submarket. So, low oil pricing has really accelerated absorption and also accelerated some supply as well down in the Southeast. So, that part of the market is doing very, very well. I’d say if there is a middle ground, it’s more on the consumer side. And that continues to do just fine. Vacancy is as good as it’s ever been for duration in Houston. Supply has started to equal off to demand. So, we are pretty comfortable with our portfolio. It’s performing. Our role is reasonable in ‘17 and even more reasonable in ‘18. So we will stay at it. It’s not maybe what it was one day. But if you looked over the last 20 years at any market in this country, Houston is doing pretty okay in comparison.

[Phil Hawkins:]

I guess real quick it’s certainly doing much better than what I would have expected or feared 2 years ago. It’s held up pretty well. And I look at our own development pipeline, it took us a little longer to lease, but we are now either fully leased or in one case, have a lease outstanding for signature that we fully expect to get signed. So we’re fully leased in our development portfolio. Rents are probably down from peak, but they are above our pro forma. So, despite a little longer lease-up time, our yields are at or above pro forma as well. If that’s what Houston looks like, I am okay with that.

[Blaine Heck:]

Alright, that’s great color. Thanks, guys.

[Operator:]

The next question is from Michael Mueller at JPMorgan.

[Michael Mueller:]

Yes, hi. I was wondering if you could talk a little bit about the acquisitions you closed in the quarter. It sounds like the going-in yield is 5.4%, expect to stabilize at a 6.1%. I know you bought one building that had some vacancy in there, but it looks like some of the other ones that are 100% leased are in the 7s. And just kind of what’s the upside that you’re seeing kind of getting up to a 7% in some of those that are 100% leased than – just if you could just add a little color into that? That would be great.

[Phil Hawkins:]

Well, I will start with a couple. I have already talked about Southern California, so I think I’ll skip that, be happy to follow up on any questions on that. And then Northern California, it’s an interesting story. It’s a really small building. It’s a FedEx facility, seller needed to close quickly. We were the – it was an off-market deal. Our guy was in touch with them and we ended up negotiating a transaction. There is only a couple of years left on that lease, which affects a typical buyer of those facilities. And we love that location. It’s irreplaceable. From that facility’s perspective, you couldn’t get that kind of zoning. There is no land anyway. It’s in San Leandro. We think it’s highly likely that FedEx will keep that space. If they don’t, we also like the market for a similar type of use. It’s that last mile delivery type building. So, we love that location and we think – believe it or not, even with that high yield, we think rents are materially below market. I will turn it over to Neil. He talked about Cincinnati, which has the partially leased going up, but why don’t you talk about Chicago, which is the last of the fully leased? Dallas, too, I am sorry, Dallas and Chicago.

[Neil Doyle:]

Yes, I will touch on both of them. So Taylor Road, Michael that is right in the heart of the I-55 submarket, obviously not a very large acquisition. But as we alluded to earlier in the call, when you get into these submarkets – and over the last 20 years, I-55 is a great example of cornfields turn to a mature submarket in a period of 20 years. There is very little, if any, land left. You are essentially manufacturing any land today in that submarket. And so when you can find an asset, two things, if you are going to find an asset below replacement cost, significantly below replacement cost and it’s an A asset, we are going to make a move on it. And two is, typically, when a submarket accelerates that fast, it was done by big boxes. And eventually, those big boxes need to be served by smaller boxes, whether it’s suppliers and whether it’s just smaller feeders to that asset. So, I think it is a pretty natural transition and we were able to come upon this in an off-market deal. And obviously, it’s not a lot of money, but it’s a very solid asset that we are going to hold for a long time. If I moved over to Commodore Drive in Dallas and that’s in Carrollton, where we just developed the Frankford Trade Center last year, but this is a group out of Louisiana that had owned this asset. We purchased a building from them in 2013. We maintained the relationship. It was time for their fund to exit another asset. That asset happened to be next door to a building we already own – that we just constructed. So, we were able to make a good buy on a 30-foot clear Class A building leased to a tenant we know very well. And I think being off-market and surety of close allowed us a slightly higher than market anticipated yield.

[Michael Mueller:]

Okay. Okay, that’s helpful. Thank you.

[Operator:]

The next question is from Tom Lesnick at Capital One.

[Tom Lesnick:]

Hey, guys. Good morning. I guess first, I know you have given a fair amount of market color already, but some of your peers have alluded to kind of a bifurcation between Inland Empire West and Inland Empire East, particularly with leasing velocity kind of tailing off in the east side of the market. Just wondering what you are seeing, if there is any color you can add to that?

[Phil Hawkins:]

Well, I think it sounds a little bit more dramatic than what I would have described it. Our portfolio, both development and existing, is in the Inland Empire West, and then also then some a little bit in Orange County and L.A. County. So we don’t have a lot of direct experience. My impression is the Inland Empire, both East and West, is doing very well. Vacancy rates, typically for large boxes, are low. Demand is healthy. There’s more supply in the East, that’s where the land is. And so I think my impression is it’s doing just fine. I don’t have any direct experience to offer any additional color than what our peers have already talked about.

[Tom Lesnick:]

Alright, that’s fair. And then my second one, cap rates seemed to have continued to compress a pretty good amount this year. And as you kind of look forward to the next 6 months to 1 year out, how does – kind of where your stock is trading and where private asset sales are how does that kind of change your calculus in how you are thinking about capital sources?

[Phil Hawkins:]

Well, stock price affects our thinking, if that’s the question. Asset prices though are still pretty attractive. And as Matt already mentioned, we have got some buildings in Indianapolis that are under contract. Buyer has waived due diligence. So, we expect those to close in the next couple of weeks. I think we are going to continue to look at capital sources in light of our options as well as, frankly, the use of that capital. It starts with uses first before we even go out and think about raising capital. So I don’t know if that answered the question.

[Tom Lesnick:]

No, that’s helpful. Thanks, guys. Appreciate it.

[Operator:]

The next question is from Rich Anderson at Mizuho Securities.

[Rich Anderson:]

Okay. Thanks. Good morning. So Phil, you mentioned over under you thought you would be over in 2017 in terms of development spending versus this year. And then I kind of just want to back – connect the dots on pre-leasing percentage, obviously a lot of moving parts at 40% today versus 46% last quarter. So, where do you get – what’s your floor on that before you can sort of get incrementally more aggressive from a development perspective? Is 40% the floor or are you willing to see the pipeline in its entirety to go below that to forward the development effort?

[Phil Hawkins:]

I would not say – I would not answer that with any definitive statement. We are looking at it on a project by project basis. We clearly have identified the opportunity to develop spec, the willingness to do so. As the cycle has matured, as our company has matured, we have projects at various stages. So in the early days, we were at – some of the people on the call will remember we were at 8%. Actually, Matt just said 7%. And it worked out great. Although we had a call or two where we talked a lot about development leasing, I would prefer to not get back there. And I would doubt we would. I think about it more on a company-wide risk management basis. We have said no more than 10% of our company’s assets, is at risk in terms of development, un-leased development. We have not come anywhere near that. Even when we were at 7%, we weren’t that close to it. But nevertheless, I think about there when you start a project like we did in Tracy, 700,000 square feet, and you stabilize two buildings in the third quarter, that obviously moves that pre-leasing number around. We created a lot of value with what we stabilized. We are going to create a lot of value with what’s in the pipeline. So, I am comfortable obviously with 40%, be comfortable if that came down a little bit. I hope it doesn’t come down a lot more, but if it does, I will explain our rationale and our thinking at that time.

[Rich Anderson:]

Okay, fair enough. Is there any change to your land strategy or do you find yourself buying more land at a faster pace today in preparation for next year or is that not the case?

[Phil Hawkins:]

I would say no change. Our strategy remains to avoid land banking. We are looking to buy land that we believe is in a market and with economics that we can develop now. And so we are thinking about – and we also we don’t want to get too much land in any one market. We don’t want to compete with ourselves. We don’t want to get overexposed to a market. And I have used Houston as an example, where Justin did a great job building, identifying land sites, sourcing them and bringing them in, developing. And then when the market is now going through the oil re-pricing, we had no land. Now that to me is perfect. And we obviously had a few development projects we had to lease up. They did and frankly thrilled that they leased up at yields that were consistent with or better than our pro forma. That’s still our mindset. As bullish as we are about this business, we are not trying to get too exposed in any one market in terms of land or development.

[Rich Anderson:]

Okay, fair enough. Last question on the acquisition front, is there any kind of shift into doing more opportunistic type deals, you have a mix of them in your latest activity as a way to counter some of the compression of cap rates and almost give your acquisition pipeline a kind of a development effort in disguise? Is that kind of one of the ways you are looking at acquisitions how that might change in the future?

[Phil Hawkins:]

I would say we have, from almost day 1, we have been focused on trying to find value-add acquisitions where the risk – where the asset was great or we could redevelop it into a great asset. But the economics also justified the effort and the risk. This market for all acquisitions, value-add or stabilized is tough. And so what you have seen that we buy now really has more of a story behind it in terms of the asset itself and the economics over time. You are not going to see huge volumes of acquisitions out of us. I would be surprised, anyway, you never – we will look at things and we are always talking to people from large portfolios down to small one-off buildings, but I think given where the economics are and where we are in the cycle, what you see in the third quarter is probably a little bit more than you would – is normal, but it’s pretty typical. Each building had a story. We are associated with that market, that submarket. We own the building next door or we happen to have a relationship with the seller that needs to move quickly and with certainty. That’s going to lead to getting a few deals done. The deal in Denver I mentioned is an off-market transaction where we had a unique relationship that is going to translate into what I think is a pretty interesting deal. It’s stabilized. However, the tenant rolls in the near future and we are highly confident about that situation, but it’s fully leased. The pricing and the risk though is reflective of the fact that we could roll that to market pretty quickly. So anyway, not big volume not probably a lot of consistency relative to value-add or stabilized. We are just looking for good assets that will generate good growth over time.

[Rich Anderson:]

Perfect. Thanks very much.

[Operator:]

The next question is from Bill Crow at Raymond James.

[Bill Crow:]

Good morning, gentlemen. I think we started this call talking about tenant behavior. And I just wanted to dig into that a little bit more and specifically on the e-commerce front. Phil, are you seeing any change in the pace of demand from e-commerce tenants? And then the second part of that is do you get any sense that the expansion might be overdone, too quick, kind of a repeat of the tech scene that we saw in office back in the late ‘90s or is everything just booming like it has been over the last couple of years?

[Phil Hawkins:]

Good questions. First, from a demand perspective, clearly e-commerce has a major influence on our business, and in fact, a major influence, even on a lot of our tenants. And I’ll give you an example. It’s not a precise number, but we did a survey of our customers and 30% of our customers, whether you do it by ABR or by square footage, say that e-commerce activities represent a portion of the activities in this space, not all of it, clearly, some are all of it, some are maybe a smaller percentage. That’s a pretty impressive number, which to me confirms that you’re probably, in terms of the actual amount of space fully dedicated to e-commerce, the estimates of 10%, 15%, maybe even 20% are in the right ballpark. It’s clearly an important phenomenon that is without denial. I have – I know some people are thinking, is this a land grab? And that is not in my opinion, what’s going on here. This is thoughtful, rational perspective. They are trying to meet current demand. And if you look at Amazon, FedEx, UPS, the most obvious companies really in many ways dedicated to or fully tied to the e-commerce world, they are behind, they are not ahead. They are continuing to ramp up capacity to meet last year’s demand and try to get close to this year’s demand. Now, if you believe e-commerce is a temporary phenomenon, that’s a different answer then. I don’t believe so. I think the convenience – what we have seen is that e-commerce has moved from people trying to save sales tax, are willing to wait a week or two to do so on items, books and electronics. And now books aren’t even a part of it. I mean, it’s all electronic. We now are focused on rapid speed of delivery, competitive price, but not necessarily sales tax benefits. And we have all become – I don’t know all, but many of us, including me are reliant on e-commerce channels to do a lot of our shopping. Whether you are young or old and I put myself in the old category, I think it’s a convenience and a benefit of – that is hard to imagine going away. Once Amazon taught us that we needed it and we never would have imagined it 10 years ago, I don’t think we could live without it. I think it’s no different than Steve Jobs and the iPhone, who would have thunk or the iPod even, who would have thunk? I just don’t see it going away. And we – when I see and talk to customers – and in fact we did a panel at one of the other house’s investment day – investment conference. And that panel of users and participants, they had a similar, if not a stronger view that this is not a land grab that’s about to turn over on itself, but this is something that’s still in the early innings and will be, I think a positive influence on our business for a long time.

[Bill Crow:]

It’s great. Thanks for the color.

[Operator:]

The next question is from Mitch Germain at JMP Securities.

[Mitch Germain:]

Good morning, guys or good afternoon. I am just curious, Phil about your – going forward, your approach to dispositions. Are they going to be more opportunistic given the fact that you pretty much have transformed the portfolio to market mix that you are more comfortable with?

[Phil Hawkins:]

I think, no, to me, they will be an important part of the way we fund our growth and been driven as much by our view of economics as by the building function. The three Indianapolis buildings that Matt mentioned, there is a couple left in Cincinnati, probably a couple around the country what I would describe – I mean, clearly, probably count them on two hands, maybe even one hand after Indianapolis is gone, where we are selling them, because functionally we just don’t think they are consistent with what we want on a long-term. But from here, it’s a function of economics, using dispositions to fund, self-fund, if you will growth. And you will see them. We got ahead of it, dispositions early in the year. We did tap the ATM a little bit in the third quarter. But dispositions will remain, I think the most important source of capital for us to fund our growth, fund our development, fund our value creation and revenue enhancement activities.

[Mitch Germain:]

Great. Thank you.

[Operator:]

The next question is from Eric Frankel at Green Street Advisors.

[Vince Tibone:]

Hi, this is Vince Tibone. We have heard that obtaining entitlements has been taking increasingly longer and also becoming very costly. Could you discuss some of these entitlement trends in some of your markets? And do you think it’s having any impact on constraining supply? And it looks like at your Arthur Avenue development, that some of the entitlement costs were pretty significant on that project.

[Phil Hawkins:]

Sure. Neil, do you want to handle that?

[Neil Doyle:]

Sure. If I just go to Arthur in itself, Vince, Arthur was a redevelopment where we took a building out of service. And in expanding the trailer park and the auto park and etcetera, we ran into storm water management, known issues, known challenges. But if you know where that building is at and you know that business park, the old Centex business park, which is essentially Elk Grove Village, Illinois, you have got 100 million feet without any storm water detention. It’s a real challenge. So whoever wants to knock down or significantly rehab a building there, you are adding detention. And there’s really nowhere to do it. And so it’s expensive and it’s quite sophisticated in how it has to get done. So that’s a known issue, but it’s not going away. But the market certainly demands that it happens and the market will pay you for it. Overall, when you go through entitlements, first of all, are you an infill company? And if you are well obviously, there is no grass where you are building. You are replacing something else, sometimes, something of significance. There is often lack of public infrastructure in the area, whether it would be a storm water detention or whether it be a third lane for truck maneuvering. So, most of the municipalities are going to try to tag the developer with their “fair share” of off-site work. And that is very common in an infill environment. So time, it’s sophisticated; money, because the municipalities generally don’t have the money to do any work themselves. So when you ask for the right to add a development to their town, you are going to get hit with some costs. So we are seeing a little more time, a little more money. But that’s where we want to be long-term. And if it’s worth building, it’s worth the time to do it right.

[Phil Hawkins:]

And I would just add one more thing, I think absolutely one influence on why supply remains somewhat in check, even in non-infill locations, entitlements are getting tougher. But where customers want to be, where the demand is and where the money is to be made, it takes longer and it costs more money.

[Vince Tibone:]

Yes, thank you. Yes, it doesn’t sound like there is any meaningful changes then in that trend. One more quick one could you comment further on the Indianapolis disposition, is that a market exit or discontinuing permitting of the portfolio?

[Phil Hawkins:]

Well, it’s really more of a – well, two things. The three buildings we are selling are definitely buildings that we have identified as buildings that just don’t fit with our long-term strategy and I think the buyer – it would fit better with the buyer’s interest and objectives as well as probably capabilities. Indianapolis is not a market where we put people and we have not invested money. And we will be down to, I think, two buildings after this. We certainly like the market, but I don’t think we bring any strength, unique attributes to that market that others aren’t already doing as well or better than we can. So I don’t consider it likely that we will expand. And quite possibly over time, we will exit.

[Vince Tibone:]

Okay, thank you.

[Operator:]

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

[Phil Hawkins:]

Hey, thanks everyone for joining the call today. We appreciate your interest in DCT and look forward to seeing many of you hopefully at NAREIT in a little over a week. Take care.

[Operator:]

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