Duck Creek Technologies, Inc.
Q4 2016 Earnings Call Transcript

Published: 3 Feb 2017

[Operator:]

Good morning and welcome to the DCT Industrial Fourth Quarter 2016 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 also note that this event is being recorded. I would now like to turn the conference over to Miss. Melissa Sachs, Vice President of Investor Relations. Please go ahead.

[Melissa Sachs:]

Thanks, Andrea. Hello, everyone and thank you for joining DCT Industrial Trust’s fourth quarter and full year 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 financial results and our 2017 guidance. Additionally, Bud Pharris, our Managing Director of the West Region, will be available to answer questions about the markets, development and 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 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. Thanks for joining the call. DCT’s fourth quarter was a strong finish to an excellent year. Our business continues to perform very well, supported by market conditions, which remain as good as I’ve ever witnessed in my career. DCT’s consolidated operating occupancy increased to 97.2%, 100 basis point increase over last quarter and a 280 basis point increase over year end 2015. Rates on leases signed during the quarter increased 19.3% on a straight line basis and 8.9% on a cash basis over the expiring rents. Our high occupancy and rent growth led to an 8.9% increase in fourth quarter same-store NOI on a cash basis and 7.4% on a straight line basis. 2017 is off to a good start as well with 612,000 square feet of new leases and 440,000 square feet of renewal signed so far. January results include backfilling our largest known 2017 move out in Atlanta with no downtime and renewing three quarters of our 2017 Houston explorations. The straight line rent spreads on these two transactions were 22.6% in Atlanta and 17.3% in Houston, consistent with our view that rent growth will continue to be a major driver of our results throughout the year. And we expect these positive market fundamentals continue throughout 2017. Tenant demand remains strong with no noticeable change behavior since the election. Market vacancies are 6% or less in our markets and new supply remain disciplined and rational both in terms of start levels and developer leasing behavior. Strong manufacturing numbers in recent months also are a positive indicator of continued healthy future demand for distribution space. Our development program continues to achieve results well ahead of our initial projections for each project, creating substantial value for DCT. During the fourth quarter, we stabilized four development and redevelopment buildings totaling 877,000 square feet with a projected investment of $79 million and an anticipated weighted average yield of 7.4%. Based on CBRE’s average Class A cap rates for each market, we estimate the assets stabilized in the fourth quarter have a current value of $38 million more than our investment, a value creation margin of 48.7%. For 2016, we stabilized $437 million of development and redevelopment projects with an estimated value of $214 million greater than our cost, 49.1% margin. We commenced construction during the quarter of six buildings, totaling 1.3 million square feet located in Chicago, Dallas, Miami and Southern California. Our current development pipeline is now comprised of 14 projects with an expected investment of $319 million, a projected yield of 7.5%, which is at least 250 basis points above current market cap rates indicating the potential for substantial value creation upon stabilization. This combination of stabilizing 580,000 square feet and starting 1.3 million square feet during the quarter resulted in a decline in our development pipeline pre-leasing from 40% last quarter to 26%. However, leasing activity is very good on each of our projects and we are confident that the pipeline will continue to outperform our initial expectation for both lease-up and returns. Our focus will remain on our development program in 2017 as it presents the best opportunity to create value and to keep upgrading our portfolio. Just as they did in 2016, our market teams will continue to work for a few complimentary acquisitions that make sense from a quality, location and return perspective, but we expect the amount to be under $100 million for the year. With that let me now turn the call over to Matt.

[Matt Murphy:]

Thanks, Phil, and good morning, everyone. As Phil said the fourth quarter capped off a remarkable 2016 at DCT, virtually every operating and financial metric exceeded the fairly lofty expectations we had for the year. We exceeded guidance and funds from operations, same-store NOI growth and occupancy. We surpassed our capital deployment objectives adding more than initially forecast or development pipeline and more importantly we exceeded our operating and financial expectations for the projects we completed and stabilized this year. We also took the opportunity to invest a portion of this outperformance in our balance sheet, improving our credit metrics and delevering above and beyond the targets we established before the year began all of which contributed to the upgrade we received in our credit rating during the year. By any objective criteria, it was an incredibly successful year. This positions DCT very well heading into 2017. As Phil described, the operating environment in our business is in excellent shape. Market occupancies are at historical highs and tenant demand remains robust with e-commerce and other logistic trends enhancing an already solid macroeconomic backdrop. We are initiating 2017 funds from operations guidance at between $2.32 and $2.42 per fully diluted share. At the midpoint of $2.37, this represents an increase of 4.4% over 2016 FFO as adjusted. However considering the $2.8 million of casualty gains recognized in 2016, which we do not expect to recur in 2017, the growth would be closer to 6%. Similarly in 2016, we recognized approximately $3.5 million of miscellaneous income or one-time items along with about $900,000 of terminations fees. The midpoint of 2017 guidance reflects about $1.5 million of one-time items and zero termination fees. While the magnitude of miscellaneous fees in 2016 is directly correlated to the tightness of the leasing market and we believe that strong landlord friendly market will continue in 2017. I don’t believe it is prudent to count on a similar level of fees and our base case forecast. From an operating perspective, we expect our metrics to remain very strong in 2017. Our guidance is predicated upon consolidated operating occupancy averaging between 96% and 97.3%. Occupancy will likely decline modestly in the first and second quarters and then climb to between 96.5% and 97.5% at the end of the year. We are expecting re-leasing spreads in 2017 to remain consistent with 2016 as market rents have continued to perform well, rent concessions remain very low and market standard rent bumps continue to enter uncharted territory. In addition almost 40% of leases expire in 2017 were signed during the bottom of the recession, which is consistent with the lease rolls in 2016, where we averaged straight line re-leasing spreads of 18.4%. All of these factors have combined to produce same-store NOI growth in 2017 of between 6% and 7% on a cash basis and 3% and 4% on a straight line basis. The same-store pool represents 58 million square feet which was 97.1% occupied at December 31, 2016. The growth in cash NOI will be driven by excellent embedded rent bumps, strong re-leasing spreads on the square feet, which rolled in 2016 or expires in 2017 and the burn off of free rent. This is budgeted to be offset somewhat by the decline in one-time items I mentioned earlier as effectively all of the 3.5 million miscellaneous income in 2016 occurred in the 2017 same-store pool. Turning to capital deployment, we continue to be pleased with the depth and quality of our development pipeline. Our guidance contemplates development start to between $225 million and $325 million. All of this activity can be achieved on land we currently own or control and includes a number of markets such as New Jersey, Baltimore and Denver where we didn’t have buildings underway in 2016. These projects represent the fruits of many years labor in several cases as our market teams have continued to find creative solutions to develop and challenges that will allow us to bring state-of-the-art buildings, the infield locations that have been under supplied with modern facilities. We are also projecting up to $100 million of acquisitions, which are likely to be similar in nature to what we have executed in 2016. Any transactions are likely to be characterized by assets with a story where we can reposition them or that are synergistic to our existing local portfolio. Turning to our capital plan for 2017, we continue to target a funding plan which will maintain a debt to EBITDA ratio below six times. Our guidance calls for us to sell between $100 million and $200 million of lower growth assets, our guidance also calls for us to opportunistically issue between zero and $100 million of equity in addition to the 11 million we issued in January. With respect to debt, our plan contemplates between $300 million and $400 million of debt financing during the year. We expect to evaluate various sources of dept capital including potentially reopening the bonds we issued in 2013 in order to maintain their index eligibility and for another larger bond transaction later in the year. For further details of our 2017 guidance, please refer to Page 8 of our fourth quarter supplemental reporting package. In closing, we feel very fortunate to be in the industrial business as we embark up on 2017. Our business is directly in the path of meaningful changes of how the U.S. population obtained an ever growing portion of their goods. Our balance sheet is in better shape than ever as we execute on exciting value add – value creating opportunities to bring facilities to locations that will help support these dynamic today and into the future. Our portfolio is in excellent shape in physical terms and in terms of its current rolls. And we have a team in place that’s proven its ability to maximize occupancy while at the same time pushing the envelope in terms of rent and rent bumps. Most importantly, we are in a business where our customers are feeling and acting optimistically about their businesses and are willing to invest in facilities that will allow them to capitalize on the forces that are driving their worlds today. I think this as much as anything epitomizes how we at DCT view the opportunity of 2017 and beyond. With that, I’ll turn it back over to Andrea for questions. Thank you.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions] At this time, we will pause momentarily to assemble our roster. Our first question comes from Craig Mailman of KeyBanc. Please go ahead.

[Craig Mailman:]

Thanks guys. Curious, Matt, your comments on rent spreads being consistent from 2017 versus 2016. Do you assume any market rent growth in that kind of assumption? Or is that just on current market rent? Just trying to get a sense if there’s potentially even more upside of market rents continuing to grow.

[Matt Murphy:]

Well, I think, there could be upside if market rents grow more than we think. Yes, there’s always market, you know, it’s not. I don’t assume it from a market down. I assume it from a lease up, but clearly there is a market rent growth embedded in some of the assumptions of what new leases will be in 2017.

[Craig Mailman:]

Ballpark about how much you guys have embedded?

[Matt Murphy:]

Really, 3 to 5. There’s going to be some – certainly some markets that are higher than that and probably some that are less. And again, it’s not about what Atlanta is doing or what Dallas is doing. It’s about specific submarkets and locations within those markets.

[Craig Mailman:]

Okay, that’s helpful. Then just a follow-up on development. Phil, your comments about kind of good activity across the board and you’re feeling about kind of exceeding underwriting and expectations is helpful. Just curious, though, looking at kind of where starts guidance is coming in and the current leased rate of the development pipeline, where outside of New Jersey, Baltimore, and Denver, where you guys feel comfortable starting more spec? Or maybe where you’d want kind of build to suits to add more products to specific market?

[Phil Hawkins:]

Well, I think, our pipeline for this coming year and just what Matt mentioned will likely include another project in Atlanta, South Florida, perhaps Orlando if leasing happens, we will take leasing, Pennsylvania. We have Valley. We’ve got a project that is likely to – it’s not on our balance sheet, but we’re going through what we think our final stages of approvals and entitlements. Maybe some leasing, we’ve got several great sites in Seattle both in the Northern Kent valley as well as further down and also building two beyond that in Northern California, smaller. We’ve got a 750,000 foot building underway in the Central Valley. We’ve got a couple of infill sites in Northern California that we are working on that we hope will be successful. And so, you’ll see activity there more likely in the 100,000 to 300,000 foot range rather than the 750,000 we’ve got going. We have one, maybe two build to suits. We are likely and hopeful of pursuing in Houston, a market you haven’t seen from us for a couple years, but we’re sitting in both cases actually it’s expansion related, existing tenants and in fact the lease I mentioned in Houston, they renewed their current buildings and they are now likely to do a build to suit with them for a third building as part of the same complex. So it’s nice to see expansion. And same with the other build to suit in Houston, we’re working on earlier stages on both the land as well as the deal, but then again that’s driven by expansion, which is nice to see.

[Craig Mailman:]

Great, thanks guys.

[Operator:]

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

[Rob Simone:]

Hey, guys, good morning. A competitor of yours came out and gave basically kind of you know talked about Houston in a very different light from what you presented. Are you guys kind of seeing any tenants in your stabilized portfolio maybe push out their leasing decisions or kind of talk about potentially terminating or not renewing?

[Matt Murphy:]

Yeah, I think what I can say is I think our team did a really good job of getting out ahead of exploration, so we didn’t really have a whole lot of exposure to last year or this year. And as Phil mentioned of the 400,000 we have expiring this year, it’s buttoned up a little over 300,000 of it. So, I think, our opportunity set to answer that question is perhaps smaller, but what I can tell you is we were 97.5% occupied as of 12/31 and some tenants are making decisions. I think – so I guess the only way I can answer that is not in my own experience in terms of what I’ve discussed with our Houston team. And also I’d back up and say Houston as an overall market is in good shape, far better than you might imagine or maybe all of us would have imagined three or four years ago. And our portfolio where we sold $100 roughly over the last couple years of higher finished products that is more exposed to the upstream oil and gas exploration production and we also have a greater exposure to the southeast as well as the northwest submarkets, which have less supply and better demand characteristics. The North is doing fine. It’s just been a little bit oversupplied. To think about Houston, I’m encouraged by the fact that under construction has come down by half, no absorption has picked up and maybe some of the best supply/demand dynamics we have in the country. No, I’m not trying to hype it up, but it’s just on paper, I look at Houston and I am very thankful that the market has been disciplined. I think it’s a great example of how the new world order works with institutional capital and equity capital and also the fact that Houston like other markets is seeing strong demand characteristics from consumption. Amazon has now entered into Houston. I was down there on a panel for NAIOP in October I think it was. And one of the questions that audience would ask themselves as well as the panel was why hasn’t Amazon come here and there have been number of reasons, but now they’ve made an entry, and so e-commerce is becoming I think more of a factor. I’m not here to tell you that Houston is the best market in the world, but boy it’s far better than I might have heard three or four years ago.

[Rob Simone:]

That’s really helpful. And just one quick follow up, since Houston feels pretty good, I’m just wondering if any of your budgeted occupancy climbs this year is emanating from a market or two that you might be concerned about versus just kind of creating vacancy to maximize price.

[Matt Murphy:]

Well, I don’t think occupancy or any vacancy is emanating from markets we have concerns about I think probably the most move out we will have in 2017 as a market will be in Chicago. We’ve got two 250,000 spaces that are expiring one in the first quarter, one in the second quarter that we’ve known for a long period of time are going to move. That’s not an indictment of Chicago. In fact I think in both cases, they’re moving on to bigger facilities that we couldn’t accommodate. So no, I don’t think of – I don’t really think of us as having submarkets are buildings that have challenges. You have expirations that happen in the tenants either there are some that are downsizing, but the majority of people that are moving out are moving out because they’re moving to bigger facilities.

[Rob Simone:]

Great, thanks guys.

[Operator:]

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

[Jamie Feldman:]

Thanks, good morning guys. So, you gave a pretty robust or pretty positive outlook on 2017 and certainly you’re off to a great start with leasing, a lot swirling out there on the global trade stage and policy risk. Just can you talk us through how you thought about giving guidance, and I mean I guess what kind of conservatism you’ve built in guidance, and how you kind of bake in to those global risks and trade risks to giving an outlook and just thinking about your business for the next year?

[Matt Murphy:]

Well, as you can imagine, we just had a board meeting over this week and this was a key topic as well as at our October planning meeting even. There certainly always is and certainly currently is uncertainty and unpredictability with respect to a lot that’s going on in Washington D.C. and another major capitals across the globe. It just seems to me though – and I’m going to give you an example in a second. It seems to me though that the expansionist pro-growth instincts of the administration as well as both branches of Congress will be a net positive for our business. The better the economy does, the better the consumer feels, the better job growth is the more products will be needed and they’ll go through a warehouse and hopefully they’ll go to one of our warehouses. And to the extent trade policy and policy shifts some production back onshore from offshore that also will create net demand for warehouse space because every time you build another car here or whatever you’re building that needs a warehouse or more than one warehouse or components to go through. And the sense in our board, we’ve got people from a variety of different industries, which is a great and their sense is consistent with that. Let me give you an example that that tenant I talked about in Atlanta is a – can’t use their name, but they’re global, very well known company focused on consumer electronics and household appliances, headquartered outside the U.S. And if not all of their production maybe most of it to me a lot of it is offshore that their processes as far as we know to find space in Atlanta started after the election and then finished in the month of January quickly, decisively and showing no flinching whatsoever about sort of the turmoil surrounding all of us. I think their belief is, if you got a good economy, consumers are going to be buying in Atlanta. They better serve that consumer base if they want to continue to maintain or grow their market share. That’s just one example, but it was crystal clear to me that at least there’s one out there, one company that is just business as usual. We’ve got a good economy; we’ve got good demand; and they need the service.

[Jamie Feldman:]

Okay. And then, when you think about how much visibility do you think you have in like the back half of the year in terms of leasing pipeline? It sounds like development starts, you’ve got a pretty good sense of what you could get done.

[Matt Murphy:]

I wish we had a crystal ball that gave us great visibility in the second half of the year. Honestly, what we expect to happen in the second half of the year is where the risk and the opportunity is and in the last couple of years it’s gone far better, better rents, where everything we’ve seen from the economic numbers, I mentioned manufacturing. But there’s a lot of positives going on in the job report today. I think there’s a lot of reasons to be hopeful. Despite, and believe me, we are mindful of the uncertainty and what that could do. We can adjust our starts in the second half of the year to reflect what may happen in the market, good or bad. But we – the other good thing about our year, good or bad, actually

[Jamie Feldman:]

All right, great. I appreciate hearing your thoughts. Thank you.

[Operator:]

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

[John Guinee:]

Great. Thank you. Could you do us a favor, Phil, and move up your reporting so that you are the first industrial REIT to report and save us a lot of angst?

[Phil Hawkins:]

No. I’d like to get it out of the way sooner; I can start my vacation. But no, Matt, we do have to get the numbers done right.

[John Guinee:]

I am looking at your G&A. You guys are not allowed to take vacations; come on. A quick minor question

[Matt Murphy:]

Yes; don’t think of us as being, there’s nothing unusual in terms of seasonality or things like that I can think of. I think what’s happening is, revenues are growing faster than expenses. And therefore you’re seeing that relationship change. There is nothing that comes to mind. I made this comment a few times internally. As it seemed like there was less, year end always has the opportunity for volatility as you’re truing up TAM, as you’re truing up accruals. It felt like the fourth quarter this year was about as smooth as it gets. I can’t think of anything that seems relevant to your question, because it seems like it was all pretty straightforward.

[John Guinee:]

Well, nothing is ever relevant to my question, but thank you for making it relevant. Next question, last question

[Phil Hawkins:]

I would say it’s more market based that it is product based. And by that I mean, in some markets, in Southern California, it’s so competitive that everything is priced well. And other markets, for example, Atlanta, where the smaller boxes have just started making sense from a rent perspective; rents have just gotten there. I think it’s not the yield that I like about the small, medium-sized box trade. It is actually the relatively lack of supply, less supply in that area versus big-box, which, as you know, institutions love big-box. They get a lot of money out, it’s sexy and it’s that 100,000-foot building, 200,000-foot building. Takes more work. It takes as much work to build the 100,000-foot building as a million-foot building. And so I more like the competitive dynamics. I’m not sure there’s a difference in yield. I haven’t thought about it that way, so I could be wrong little bit. But, as I said, it’s more about competitive dynamics and risk return rather than absolute return differences.

[John Guinee:]

Great; thank you; have a good vacation.

[Phil Hawkins:]

Thanks, John.

[Operator:]

Our next question comes from Manny Korchman of Citi. Please go ahead.

[Manny Korchman:]

Hey, guys; good morning. Matt or Phil

[Phil Hawkins:]

Houston was a renewal. And in the case of Atlanta, it was consumer going out; I could say it was Smuckers, which we expanded them into a new building and a new company which is consumer, although, consumables versus the newcomer coming in is more durables; consumer electronics, appliances, that kind of stuff both consumption-based. And so, in terms of fourth-quarter leasing or anything that’s going on, Matt, that you’re seeing shifting?

[Matt Murphy:]

No, I mean, not surprisingly, the industry that was number one at leasing the fourth quarter manufacturing, which has been probably six of the last eight quarters has been true are manufacturing-related; that’s what they identify themselves as by GIC code. So, no, I can’t think of anything where you’re seeing one thing picking up and/or another thing tailing off.

[Phil Hawkins:]

I can tell you one prospect we have for a redeveloped building in the Midwest is a 3PL that serves the auto plants of one of the major auto manufacturers. They’re expanding and they are moving out of the building because of that need for expansion into ours. And so, manufacturing, home-building; and not manufacturing in our buildings, but every time you build something you need parts, components that go through a warehouse. And the manufacturing supply chains are just as complex if not more so than the consumer e-commerce and traditional supply chains. And they are spending as much money and time on expansion as well as refinement of their supply chains as the consumer side. All that’s good, frankly, for us.

[Manny Korchman:]

Great. Matt, can you talk about the average rental bumps across the portfolio? And also on new leasing, especially if there’s any difference between those two numbers?

[Matt Murphy:]

Yeah, like I have mentioned in my opening comments, they continue to get better and better. I’ve always thought it’s funny how the benchmark’s gone from maybe 2% a few – or a couple of years ago, a few years ago to 2.5% being the sign of a good one. Our average bump in 2017, the ones that are contractually established already, is 3.1%. So they don’t go – it’s not like it goes from 2.5% to 3.5% to 5.5% and I would always thought about this in terms of layers

[Manny Korchman:]

Great. My last one on that same thought

[Matt Murphy:]

Yeah, I think, we talked about it throughout 2016, and it’s now manifesting itself as a comparison to 2017. There is clearly a lot of free rent in our numbers in 2016. I think it’s a tool that, if used effectively by our leasing teams, where you’re seeing maybe some companies that are willing to give you a dollar and a quarter tomorrow for a dollar today, that me as a finance person wouldn’t make sense. The raw numbers are, we had about $11.7 million worth of free rent in our same-store pool in 2016. What we know of in 2017 is a little over $2 million. Now, what I say, I would say that way because we will have free rent associated with new leases that are moving in, in 2017, so it goes up from there. But if you just look at the comparison of what we know was in 2016 versus what we know is in 2017 that $9 million plus number is almost 400 basis points of same-store growth. Our total same-store NOI in cash NOI in 2016 was about $250 million. So there’s a lot of visibility into that, a lot of that is based, if you will. And then there is obviously the variable part of it is how much of it will happen next year and I have assumption built into guidance, but I am guessing…

[Phil Hawkins:]

Next…

[Matt Murphy:]

Yeah, I am sorry, 2017…

[Phil Hawkins:]

I’m turning the page today…

[Matt Murphy:]

I’m speaking of 2016, so hopefully that’s helpful.

[Manny Korchman:]

Great. Thanks guys.

[Operator:]

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

[Eric Frankel:]

Thank you. First question is I guess kind of detail. Can you explain in your development pipeline, it looks like a few of your projects you delayed a quarter or two? Is there an overarching reason for that trend?

[Matt Murphy:]

You’re talking about completion start…

[Eric Frankel:]

Yes, completion, sorry.

[Matt Murphy:]

No. I can’t think of an overarching theme. I know we had one of the ones that was going in Chicago that had some sort of regulatory issues that took us, the central one that – the FedEx deal. I don’t think of any, I can’t think of any overarching ones. Construction, we typically are going to budget eight months, nine months and that almost – it happens that way, getting fully underway takes longer. I can’t think of a single answer to that.

[Phil Hawkins:]

To summarize that up, Eric. The two that I’m familiar with are site-work related. I think you know, you’re familiar with the FedEx location; there’s a lot of on that site. And frankly, it just took us a little bit longer to clear it and get through all the obstacles that weren’t necessary on any drawings. The drawings didn’t exist. So that delayed it. And similarly, another project I’m thinking about, same thing, is that demolition work took us a little longer. When you’re getting into redevelopment of sites, building new buildings, or redeveloping buildings, it’s a little bit different than building on a cornfield. And that’s – we go in there with our eyes as wide open as possible, but sometimes you find things that you didn’t encounter. Frankly, it cost us some time, but frankly not a lot of money. And the yields on those things were so strong that, frankly, we had plenty of room anyway. But those are two that I can think of.

[Eric Frankel:]

Okay thanks. One more detail question. I will come back in the queue for a broader question. But related to tenant improvement allowances and leasing cost, it looks like your leasing costs are somewhat elevated for fourth-quarter leasing. Is there a particular reason for that? You talked about you had a lot about more manufacturing-related leasing? Is that any sort of equipment financing that’s embedded in that?

[Matt Murphy:]

So, I’m sorry; I’m pausing for a minute to look through. I’m trying to think of any specific examples that drive that, and I can’t. I don’t know Eric, I apologize. I’ll have to get back to you. I can’t think of a single one that’s driving it. You are right; it is relatively high.

[Phil Hawkins:]

But just to be clear, I don’t think we put any manufacturing operations in our buildings. And we certainly aren’t expecting to finance manufacturing equipment if they did. You certainly would build out office space; you would – new lighting if it’s an older building. Whatever it is, but we’re not going to be typically in the business of manufacturing equipment leasing or financing.

[Eric Frankel:]

Right, right, I’ll call back in the queue. I will go back to queue. Thank you.

[Operator:]

Our next question comes from Blaine Heck of Wells Fargo. Please go ahead.

[Blaine Heck:]

Thanks. Good morning guys. So Phil, at this point in the cycle, given the rise we have seen in rents, is there any desire to start pushing for longer lease terms kind of to lock in the relatively higher rents we’re seeing out there? Is that not something that’s a priority when you guys are leasing space?

[Phil Hawkins:]

Well, I would say, there is certainly less reluctance to enter long-term leases, but tenants have pretty clear views of their requirements coming in and that includes length of term. Based on their business, could be a 3PL underlying contract between a matchup. Or it could be a direct to consumer company that has its own needs and/or budget constraints. We’re probably a little less control over length of term than any other variable in the process. And I’d rather not push one way or the other against something that’s clearly important and well-thought through by a tenant. And instead push on what they can be accommodated of, and that would be economics. As soon as you start pushing on term, you may either lose the deal or you may end up putting them in a position that they’re less accommodating or less able to handle the economic proposal. But every deal, that’s why we have people on the ground, I would say, it’s a local business and a business that is run by our market leaders and their teams. You want to get to know the customers as best as you can and figure out a package that works for them as well as possible. So we can then have a package that works even better for us.

[Blaine Heck:]

Okay, that makes sense. Then maybe another one for you or Neil; I’m not sure if he’s on the line. Can you just talk about the Chicago acquisition. I know it’s small, but it looks like a stabilized 4.3% yield, which seems low for you guys. Is there sort of any value-add play there or I guess what made that purchase attractive to you guys.

[Phil Hawkins:]

Two things, and Neil’s not on the call. And Neil and Todd Vezza, who runs that market for us, love that location. Close in kind of that last mile or last half mile kind of location. But the in place leases, which are substantially below market, 30% or 40% below market, is what creates the low yield. A price per foot in discounted replacement cost we like a lot. It is going to take us a couple of years to get at it. But it’s an example of how we are willing to invest in great real estate with future potential, but not necessarily needing to have a current return. We’ve got a portfolio that is quite diverse in terms of returns. And we really want to think about the right real estate with good growth prospects long-term. And not just think about this year or this quarter. So we love that building a lot.

[Blaine Heck:]

Makes sense. Thanks guys.

[Operator:]

Our next question comes from Michael Mueller of JPMorgan. Please go ahead.

[Michael Mueller:]

Hi. Just a quick question following up on the lease term discussion. So it looks like in 2016, the average duration of lease side is about five years. If you are looking at the development pipeline, how does it differ there? Are they predominantly 10-year leases? Or is it something a little bit shorter than that?

[Phil Hawkins:]

Yeah, so development is about 6.5 years. This is – so year-to-date status, it’s 77 months versus an overall average of 60. So that doesn’t surprise me a bit. You’re typically going to see tenants, some of it has to do with they’ve been a little bit bigger boxes over time, and as a result you’re frequently seeing those guys put in more of their own cost into the building. They also have a longer transition time. It is just a bigger investment. Those guys tend to go longer.

[Matt Murphy:]

Generally speaking, new leases are longer than renewals. There’s exceptions to both. So you obviously have no renewals in the development pipeline and 78% of our leases, roughly renewed last year. So that’s also going to push down on it. I think our operating portfolio average churn was up almost the full year from four or five years ago, where we did a lot of renewals. And it was in the low 40% – for 40 months wasn’t it? If I remember right which does not surprise me, either as you are doing more new deals tenants are more confident, spending more money on space, they’re going to want longer-term.

[Michael Mueller:]

Got it. Okay. That’s helpful. Thank you.

[Operator:]

Our next question comes from Tom Lesnick of Capital One Securities. Please go ahead.

[Tom Lesnick:]

I’m sorry I was on mute there. Hey, guys, good morning. I guess, first off, you mentioned good leasing activity in Atlanta and Houston. Looking out to 2017, are there any specific markets that perhaps carry a little bit more of the bulk of the share of the leasing?

[Matt Murphy:]

Well, I think – so we have basically 20 expirations that are 100,000 square feet or greater during the year. Five of those – 5 of the top 10 we know are moving out; 3 of those have been backfilled. We have five spaces that are greater than 100,000 square feet that are vacant today. One that’s greater than 200,000; that’s a 400,000-footer we have in Atlanta. Clearly, from an operating portfolio perspective, that’s our biggest bet that we’re making during the year. Beyond that it is reasonably well-distributed. We have 10% of our square feet rolling from a square footage perspective; it’s only 8% from a revenue perspective. I can’t think of why that will be terribly different from a renewal retention than we’ve had historically. So, no I don’t see a lot of concentration. The one thing to make sure that ties together, we do have pretty significant move-outs in Chicago. And as a result that we know we’ve got a lot of leasing to do in Chicago. Market’s in pretty good shape and we have good activity, but that’s where our biggest bet is for the year.

[Tom Lesnick:]

Got it. That’s very helpful. And then just a bigger-picture question. If you had to rank some of your larger markets by farthest along the cycle to not as far along the cycle, how would you go across with your larger markets?

[Phil Hawkins:]

I think the larger markets, with a few exceptions, are all about the same spot. There is plenty of capital that is able to fund on an equity basis development; supply is disciplined but active. Demand is healthy across all the markets that I see. And as a result, with supply/demand roughly in balance, maybe supply a little light of demand. Low vacancy rates; you’re getting rent growth in the – I think 2017 rent growth is going to be good. I was wrong last year. I said 4% to 6% and I was dead wrong. Thankfully I was low. I think we’re going to be 3% to 5%, 4% to 6% again this year. Because we got that little vacancy, combined with the fact that new construction, providing the new supply that the market needs, is costing more and more every day. Land costs, construction costs, entitlement costs. That’s going up 5% or 6% a year at least, in some markets more. That’s lifting the ceiling for all the other buildings. I think we’re going to be in a pretty healthy rent growth environment.

[Tom Lesnick:]

All right. I appreciate the color. Thanks again.

[Operator:]

Our next question comes from Mitch Germain of JMP. Please go ahead.

[Mitch Germain:]

Thanks. Matt, I think you said about 40% of the leases rolling signed at the low point of the cycle. Similar amount, I think you said, from last year. Does it burn off and now we are going to tick up a year as we move forward? Or do you have some of that drafting into 2018 as well?

[Matt Murphy:]

It drafts out at like 12% in 2018. So yes, as we think about average lease term, that makes sense. The good news is, is there’s been a lot of good years of rent growth between then and now. So it’s not like that’s the end of the party. But that is effectively the end of the, what I consider trough lease comparisons against trough leasing.

[Mitch Germain:]

Great. Thank you. That’s it.

[Operator:]

Our next question comes from Rich Anderson of Mizuho Securities. Please go ahead.

[Rich Anderson:]

Thanks. Good morning. So speaking of the trough leasing. I’m curious to what degree the type of cash releasing spread that you’re getting is influencing your jazzed up approach to development? And not that is a false positive, but it’s not sustainable, either. So what do you think the sustainable lease role number is, once we get through all this height of recession-type of re-leasing activity?

[Phil Hawkins:]

I’m not sure I understand the connection to development. I’ll speak on development…

[Rich Anderson:]

That was a little subliminal message of my part that I worried a little bit about the aggressive approach to development. And making sure that we’re not taking too much out of the leasing activity that isn’t going to be in this level for very long.

[Phil Hawkins:]

I heard rents and I heard leasing activity and I heard development. Let me just tell you what I think of the market. And how we think about development. We’re not underwriting rent spikes if that’s what you’re getting to.

[Rich Anderson:]

That’s right. That’s exactly…

[Phil Hawkins:]

Number one. Number two, I believe demand will continue to be broad and deep across markets, industry verticals, and sizes. That’s why we’re developing

[Rich Anderson:]

Okay. Fair enough. And then, Matt, can you give some of the building blocks, one thing not in your guidance, at least I didn’t see it, was how interest expense will ramp in contact with the development activity? Can you provide that, one way or the other, or maybe off-line?

[Matt Murphy:]

I’m happy to do it online. Again I don’t look at that from a macro-economic perspective. I look at how much floating-rate debt that we have and what we think interest rates will be for that. And I am probably not being that crazy and that I’m assuming a couple of 25 basis-point bumps during the year for LIBOR. And as I mentioned, we’re contemplating a couple different discrete financing transactions that I am basing off where market is today. It’s likely that one will happen earlier in the year. And I am basing that off where I think the pricing of that will be today. And I built in a little bit of an increase in overall rates for the one that happens late in the year. Again, I do not look at this from the world down, I look at it from our debt portfolio forward. And those are the assumptions I made around it.

[Rich Anderson:]

Right. But do you have – I mean how much more interest are going to be – I hate to be so trivial, but how much bigger can it be, 2017 versus 2016, when you consider all that?

[Matt Murphy:]

What does bigger mean?

[Rich Anderson:]

Interest expense.

[Matt Murphy:]

Well, again, I’m not going to give you a specific number on interest expense. What I’ve said is that we’re getting ranges on deployment. I told you the way I think about where credit metrics will be. And so there will be incremental debt that is added as a result of our deployment activity. There will not be incremental leverage that is added. The combination of, in the short-term, incremental debt will happen on the line. On a longer term it will be taken out with the long-term financing that I have described. And you have to make assumptions about timing and magnitude. And there’s ranges in every single element that I’ve just given you. All of those ranges will impact what interest expense does.

[Rich Anderson:]

Fair enough. Thanks very much. Appreciate it.

[Matt Murphy:]

Thanks, Rich.

[Operator:]

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

[Bill Crow:]

Good morning, guys. Phil, it’s interesting we have talked more about manufacturing than e-commerce in this call. And got me thinking about, if you were to divide your tenant base into the old economy and the new economy, is there one sector that’s growing? I mean, e-commerce has been the growth driver incrementally. Is manufacturing and old-line economy tenants, are they starting to ramp back up? Are they catching up at all?

[Phil Hawkins:]

First, almost every consumer-related tenant has got some form of e-commerce going on or they are not going to be around much longer. And that includes, obviously, Amazon, but many others. We’ve had, as Matt mentioned, manufacturing-related companies by their self-selection of the SIC code have been significant. But that also includes for example, Coca-Cola, where we did a lease with them last year maybe in the fourth quarter that they are a manufacturing company. But you don’t think of them as an old-line company. I think of them as a consumer company, but they think of themselves as they produce syrup, I guess. I think what’s going on in our business, our business is doing so well. And why I believe it will continue to do well is, we have both traditional customers, traditional businesses, both consumer and manufacturing, that are doing far better today than they were in 2009. And they are spending more money today on efficiency as well as speed and quality of distribution. Combined you know with the advent of e-commerce, which has been pretty well-documented as a less efficient use of space. You need more square footage for that business because a lot going on in our buildings. And generically speaking, that has resulted in disproportionate growth in our business relative to GDP growth. So I think it’s both. If it was just e-commerce my guess is, we’d be doing pretty well. But if not, it’s e-commerce combined then with traditional customers across the spectrum that continue to also feel good, do well, and make decisions.

[Bill Crow:]

Am I wrong in thinking that if this movement out of DC to relocate manufacturing into United States is successful, do you think supply chain, et cetera, you would have to – there would be an increase in demand? It may be too early to see that. Is that a fair way to think about it?

[Phil Hawkins:]

I don’t know if it’s fair, but it’s the way I think about it. I know there’s some angst amongst investors and analysts about trade policy and how that’s going to have a disproportionate impact on distribution space. I see it as having a net positive impact if you can assume that a trade policy and trade taxation doesn’t tank the economy. Obviously, if it’s counterproductive, all bets are off for everybody. All sectors, not just us. And maybe we have a little less exposure; who knows, because of e-commerce. But to me, if you believe that the overall economy will be doing better under, for whatever reason, I’m not trying to have a political position here, but if you believe that, that is happening and you believe that it will happen at the same time you shift production onshore, it’s got to have a net positive impact on our business.

[Bill Crow:]

Yes. All right, thanks. Appreciate it.

[Operator:]

Our next question comes from Anthony Hau of SunTrust. Please go ahead.

[Ki Bin:]

Thanks, good morning. It is actually Ki Bin. Just a couple quick ones. Can you talk a little bit about your approach to buying land? As a comparison to maybe some of your peers? I noticed your yields have been pretty healthy, maybe a little bit above peers. So maybe if you could just give us insight as to how you’re buying land? And is it more a function of markets or is it some other issues?

[Phil Hawkins:]

Let me just talk about DCT. And it’s hard for me, I don’t know our peers as well as I know us. We believe very strongly and are willing to invest time and capital into pursuing land, and solving problems associated with that land that perhaps other investors have a shorter timeframe or less expertise or less patience have. Infill focus; willing to assemble land, willing to take on environmental issues solve them with the seller. Willing to take on entitlement issues, zoning issues, solve them, Wetlands issues. I’d say the vast majority of the land we buy is not developed or assembled by somebody else and then flipped in a retail fashion. But something that we invest our time and money into creating value through the land process. I think you end up with better returns and better location. It takes longer; as I’ve said it before, there are risks. Your pursuit costs that we’re spending, thankfully we been pretty fortunate. But that is the cost of doing business the way we do it. And I think the $700,000 this year that, this year mean 2016, I’m back in Matt’s trap. So we’re going to invest in the land process and add value through land. Frankly, it’s not that hard to build a building once you have the land ready. And I had actually mentioned in one response to one other question, when you tear down buildings, things can go wrong. Once you got the pad clear, it’s pretty unusual unless it rains. And we had rain in Dallas, for example. It was raining like crazy; that pushed us back a month or two. But besides the weather, it is pretty hard to mess things up. The real value is in the land.

[Ki Bin:]

And with that said, your landing is doesn’t look that high. Does that change the yield profile going forward as you buy, I would call it, more market cost rent?

[Phil Hawkins:]

I think cost of land is going up; no doubt about it. And our yields have come down a little bit. We thankfully outperformed. But if the question is, is land, yields and development coming down, the answer is yes. But I think that we will continue to pursue our beliefs is that buying large tracts of land and holding them for multiple years is not the best way to make money in our business. Others are better at it. That’s not the only way to make money. Our way is, avoid land banking, focus on infill locations, invest in some cases two years in the process. It’s off our balance sheet. We’re not going to close on a piece of land until we are confident we can build on it. But we’re going to invest the capital and the time over a one or two-year period to do it. And we have to get paid for that. Right, I mean you got to get paid. It’s risky, it’s complicated, it takes time. We’re not trying to work for free, that’s for sure.

[Matt Murphy:]

The other thing I might add to that is inherent in that answer but it may be not obvious, is that because some of the things are taking longer and we’re solving problems over periods of time, we’ve agreed on the land price a long time ago. And I think that ultimately ends up enhancing our yields.

[Ki Bin:]

Okay, that’s actually a good point and just a larger picture question. If we think about how e-commerce has contributed to industrial demand over the past three years, a lot of it has been square footage take-up right? Absorption, is there a small bit of risk that square footage absorption turns into what I call it more cubic feet absorption? Where it’s just buildings get taller? Not sure how much more rent you get for that, if at all. But is there risk that as buildings get taller maybe the economic flow into industrial REIT or industrial landlord maybe gets mitigated a little bit?

[Phil Hawkins:]

I guess a miniscule risk if you think about the total demand and the total size of the market. The vast majority of 36-foot clear buildings for example, today, are not used by the customers as 36-foot clear. Amazon has clearly shown, and a few others, have shown the desire to use a 40, not 44 cube. But they’re not using it as a cube; they are using it as basically a multi-story sorting center and fulfillment center. They’re building mezzanine space. There’s plenty demand out there. And by the way, that does raise rent. You’re not going to build a 44-foot clear building and charge the same rent as if you built it at 28-foot clear or 24-foot clear or 36-foot clear. You’re going to get higher rents if the market’s rational. There’s no doubt that, as rents go up, customers will continue to think about, how do I use this more efficiently. That’s counteracted by the fact that e-commerce is taking over more market share. And that’s inherently less efficient. The three to one ratio is used by a lot of different companies now, both developers as well as even e-commerce companies. You have got more things going on, more people in that building, more value being added. As a result, the density of that site is a lot less; density down from probably 50% 10 years ago to 30% or 35% today. More car parking, more trailer parking, all of those things going different directions. But overall I think that the demand outlook for e-commerce and others that might use that cube is so strong that I’ll take that trade-off.

[Ki Bin Kim:]

Okay. Thank you guys.

[Operator:]

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

[Eric Frankel:]

Thank you. Just a couple of quick follow-ups. Amazon recently announced that I think they’re opening a much more expansive air hub operation in Cincinnati. Do you have any sense of how that’s going to impact their warehouse network over time? Whether maybe that actually might take away some demand from the really big population centers and make their distribution network a little more centrally located and maybe closer to airports?

[Phil Hawkins:]

I don’t have a clear sense. I don’t believe, though, that you can afford [indiscernible] leasing yourself; you do it through FedEx and UPS that you can afford to fulfill e-commerce orders across the country by air. I think what they’re trying to do is reduce reliance on FedEx and UPS and vice versa, as we saw in UPS’ earnings release. My sense is, it’s not driven by changing the pattern of fulfillment and distribution. But more trying to control their own destiny on that one leg of it. But as I understand e-commerce, they’re trying to fulfill more and more through ground, which is far cheaper and more efficient than air.

[Eric Frankel:]

Okay. And then finally, any markets where you’re seeing any sort of supplies issues? I know overall you have stated that the market’s relatively disciplined, but any markets where you think supply might be getting a little bit ahead of demand?

[Phil Hawkins:]

What we look at is 12 months of absorption, trailing 12 months, versus the unleased, the vacant portion of the supply. And everything is under 100% of that. I said this in other calls, you got to look at the markets where there’s a lot of demand and a lot of supply. And Dallas is on that list for sure where because it’s leveraged. I mean, the supply, at least in the short run, is not going to contract quickly. But demand can go away overnight. So we spent a lot of time thinking about sub markets think about building size and not trying to be where everybody else is in terms of the size. And then you make sure you limit your exposure, because it could change on a dime. But the indication so far are that the demand there as well as other key large markets, Inland Empire as an example, all are healthy from a demand perspective.

[Eric Frankel:]

Okay that’s it for me. Thank you.

[Operator:]

Our next question is the follow-up from Manny Korchman of Citi. Please go ahead.

[Michael Bilerman:]

Hey, it’s Michael Bilerman. I’m just curious whether you talked about how you haven’t seen a lot of move on the tenant front yet, post-election, and post sort of what the administration wanted to do. It seems to me that the investment market tends to move first; and so I’m just curious whether you’ve seen any either developers or private equity capital sort of target the middle of the country? Or vice versa, potentially maybe sell at attractive cap rates on the Coast or the ports? And whether there’s any noticeable shift on the investment side of the market coming out of the election?

[Phil Hawkins:]

Haven’t seen it. You’re right; it is too early, although it’s likely to go faster than perhaps tenants move. I think that there’s still – the investment market is still very strong, very few deals got retraded or even attempted to retrade in the fourth quarter across the country. Very little is on the markets of quality class A type of capabilities when they do come on the market. Regardless of which market they’re in, they have traded very well, so I think it’s too early Michael. I think that you saw the advantage of the coastal markets, that’s where the population is. So you still serving a consumer base. And it’s also where the greatest barriers to new supply are, which may delay or eliminate any reaction to any changing demands that may be happening, depending on what you think might happen out of Washington. But anyway, too early.

[Michael Bilerman:]

How many new players are you seeing either on the development side or on the investment side, coming to the industrial marketplace?

[Phil Hawkins:]

From the investment side, there’s been some money in the build-to suit-world. Thinking Chinese capital, I certainly saw GLP come here, and they remain active. I don’t think that’s new anymore. It remains in large part traditional pension fund capital, either through advisors or through well-known fund operators that whose primary source of capital is pension fund.

[Michael Bilerman:]

Cavett and the like of Exeter and companies like that. But in terms of developers, what are you seeing in terms of any new entrants in your markets?

[Matt Murphy:]

So, I’ve seen in the West, we’ve seen a number of, kind of, our peer groups, some of our bigger competitors, have decided to enter, or are looking at setting up more of an office instead of flying in from central headquarter locations. So we are seeing a little bit of that. I don’t see a ton of traction, frankly, but there has been some of that activity.

[Michael Bilerman:]

And then I have a question about the private equity players being right now instead of chasing industrial relative to, I would say other core property types. You’re probably seeing more of a deceleration and less attractive sort of investment opportunity. I’m just curious how much capital is going to continue to flood into the space.

[Phil Hawkins:]

It’s been too short of a time frame. I could tell you from inbound phone calls and discussions with some of those players, from the very largest to medium and smaller, they clearly have a strong appetite or convey the sense that they have a strong appetite for industrial. We will see where pocketbook and verbiage align. But a number of the private equity players continue to like industrial for both macro reasons and market reasons as well. There’s been no sign, again it’s too early, and certainly a lot can change in this world of uncertainty and change. But there’s been no sign, with a response to increased interest rates on industrial, that the reaction on pricing has been what appears to have been, for example, the office side that I’ve heard about.

[Michael Bilerman:]

And just last one

[Phil Hawkins:]

I don’t know, honestly. I’d love to ask you the same question and we can do that off-line. It just seems to me, though, that in the public world, every company’s got a slightly different strategy, doing well, good leadership, their own kind of portfolio that they want to have. With different quality, different types of product amongst ourselves, different market concentrations. But I can talk about DCT. I think we are in great shape with who we are, to grow organically and make money. If something came along, private or public, better company with better returns and future value creation, we’d be open to it. On the other hand, I don’t see that as a strategic priority.

[Michael Bilerman:]

Okay. Thanks, Phil.

[Operator:]

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

[Phil Hawkins:]

Okay, long call. I appreciate everybody hanging in there with us. We had a great quarter and looking forward to what I hope will be a great 2017. Thanks for joining and talk soon. Bye-bye.

[Operator:]

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