Duke Realty Corporation
Q3 2018 Earnings Call Transcript

Published: 26 Oct 2018

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to the Duke Realty Quarterly Earnings Conference Call. [Operator Instructions]. And as a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Mr. Ron Hubbard. Please go ahead, sir.

[Ronald Hubbard:]

Thank you, Greg. Good afternoon, everyone, and welcome to our third quarter earnings call. Joining me today are Jim Connor, Chairman and CEO; Mark Denien, CFO; and Nick Anthony, Chief Investment Officer. Before we make our prepared remarks today, let me remind you that statements we make are subject to certain risks and uncertainties that could cause actual results to differ materially from expectations. For more information about those risk factors, we would refer you to our December 31, 2017 10-K that we have on file with the SEC. Now for our prepared statement, I'll turn it over to Jim Connor.

[James Connor:]

Thank you, Ron, and good afternoon, everybody. I'll start out with a few comments on the national industrial markets and then cover our third quarter results. Vacancy across the U.S. declined slightly during the third quarter to 4.3%, creating a solid backdrop for pricing power, evidenced by year-to-date market rent growth approaching 6% nationally. Preliminary data shows third quarter absorption exceeded deliveries by about 12 million square feet, and the trend for the full year appears highly likely to support continued net positive absorption. Overall, new supply remains relatively in check, except for a few pockets, consistent with what we've noted throughout the year. In general, there continues to be a need for modern facilities in major markets for both e-commerce and traditional distribution across the entire logistics supply chain. Let me also touch on some of the recent macroeconomic and geopolitical headlines of late. Regarding tariffs, we are not seeing any material slowdown in decision-making from our customer base. From a practical standpoint, a 10% tariff on $200 billion of imports equates to $20 billion against a U.S. GDP of over $20.4 trillion. It's just not enough to slow our economy in any meaningful way. The tariff impact on some construction materials is consistent with what we've said the last few quarters. Steel costs are up about 15% year-over-year. Coupled with rising labor costs, overall construction costs are up 5% to 6%, similar to our previous statements. More importantly, we've been passing these marginal costs through the customers without a problem and maintaining our development margins. Specific to our portfolio, this relatively strong backdrop in market fundamentals continued with - coupled with continued expansion or execution by our regional operating teams contributed to the solid 5.2 million square feet of leasing for the quarter. Some of the more notable leases were with customers such as Home Depot, UPS Logistics, DHL, HD Supply and numerous third-party logistics firms. With the strong leasing activity and our stabilized industrial portfolio occupancy at 97.9%, we continue to be able to push rents, as indicated by our rent growth on new and renewal leases of roughly 28% on a straight-line basis and 11% on a cash basis. We reported 6.3% growth in cash same-property net operating income for the quarter. Same-property NOI for the nine months ended September 30, 2018, was 4.6%. Third quarter same-property growth on a GAAP basis approximated our cash growth and about - is about 80 basis points better than cash on a year-to-year basis. Occupancy in the same-property pool of properties increased 150 basis points from the third quarter 2017 and increased 60 basis points from the 9-month period ending September 30 in 2017. This average same-property occupancy increase was the substantial driver in the quarterly same-property NOI increase compared with the previous two quarters. The occupancy was positively impacted by the very strong leasing executed in the first half of the year. More importantly, the strong leasing and strong rent growth this quarter and year-to-date have raised our expectations for full year same-property NOI growth, which Mark will discuss in a moment. On the development side of the business, momentum continued to be very good. During the third quarter, we generated $141 million of starts across six projects, totaling 2 million square feet that are 51% leased in aggregate. The new development starts included 618,000 square foot build-to-suit development in Cincinnati for a subsidiary of the Herman Miller Corporation. On the speculative development side, we started a project in the Inland Empire totaling 340,000 square feet. Shortly after commencing construction, we executed a lease for 100% of space for Legrand Holdings, a French industrial conglomerate. We started three other speculative development projects during the quarter in our Houston and Indianapolis markets totaling about 980,000 square feet. These facilities are located in our existing business park and adjacent to the major cargo airports. We continued to see strong activity in our development pipeline, and we're confident that we'll close out 2018 in strong fashion, and we're optimistic about early 2019. Now let me turn it over to Nick Anthony to cover the capital transactions activity.

[Nicholas Anthony:]

Thanks, Jim. We had a light quarter with regard to capital transactions. The acquisition environment is extremely competitive, and we continue to be highly selective and focused on targeted submarkets and Tier 1 markets. From a pricing perspective, there continues to be a wealth of private and public capital seeking increased allocation to Class A industrial in all major markets, which continues to push down cap rates. We did have one disposition during the quarter, selling a 202,000 square foot facility in Indianapolis that was held in joint venture at strong pricing. Shortly after quarter-end, we sold 1 million square foot facility in Northeast Pennsylvania. The facility was leased to a third-party logistics subsidiary of Sears. We acquired this facility as part of the portfolio several years ago, and the location is tertiary to our core Lehigh Valley submarket. We are pleased with the execution pricing, which was north of $60 per square foot and in line with recent comps. I'll now turn it over to Mark Denien to cover our earnings results and balance sheet activities.

[Mark Denien:]

Thanks, Nick. Good afternoon, everyone. I'm pleased to report that core FFO for the quarter was $0.35 per share compared to $0.33 per share in the second quarter of 2018 and $0.30 per share in the third quarter of 2017. Core FFO increased from the second quarter of 2018 due to continued improvement in overall operating results, development properties being placed in service and lower general and administrative expenses. We reported FFO as defined by NAREIT of $0.36 per share for the quarter compared to $0.33 per share for the second quarter of '18 and $0.26 per share in the third quarter of 2017. NAREIT FFO in the third quarter of 2017 was negatively impacted by $17 million of debt extinguishment costs incurred due to repaying debt with proceeds from last year's medical office disposition. We're very pleased with our 17% increase in core FFO over prior year quarter as we have now redeployed the proceeds from our MOB sale quicker and at higher returns than we initially anticipated. AFFO totaled $113 million for the quarter compared to $107 million for the second quarter of '18 and $94 million for the third quarter of 2017. In addition to the factors impacting core FFO, the improvement in AFFO from the second quarter of 2018 was partially due to the timing of second-gen capital expenditures. During the quarter, we issued $450 million of unsecured notes at a 4.1% effective interest rate and used a portion of the proceeds to repay 2 secured loans totaling $224 million, which had an average interest rate of over 7.6%. The remainder of the proceeds will be used to fund our development pipeline. In addition to this debt funding, we raised $28 million on our ATM program at an average price of $29.24 per share. While we have plenty of internal funding capacity looking out the next 12 to 18 months, given the increased volatility trending in the market and rising interest rates and given our strong development pipeline outlook, we took advantage of a very strong equity market during about a one week window in early August. During this time, we were trading at or slightly above consensus NAV per share and at peak pricing compared to the previous two year period. We finished the quarter with $133 million in available cash and $128 million of cash held in escrows to redeploy the disposition proceeds in the near-term tax-deferred exchanges. We also have $277 million in interest-bearing notes receivable, of which $145 million will mature over the next nine months and no outstanding borrowings on our unsecured line of credit. These sources of liquidity will contribute to funding our near-term growth. Given our optimistic outlook for strong long-term AFFO growth and given our excellent balance sheet position, yesterday, we were pleased to announce a $0.015 per share or 7.5% increase in our regular quarterly dividend. Even with this increase, our AFFO payout ratio remains at a very conservative level of approximately 70%. I want to now briefly touch on some retailer bankruptcies that have been in the news. After the sale earlier this month of the Pennsylvania property that was leased to Sears that Nick mentioned just a little bit earlier, our remaining exposure to Sears consists of only four small leases totaling less than 200,000 square feet that are being used for high-end appliance distribution. We also have two small spaces totaling just over 100,000 square feet with Mattress Firm and one leased for 120,000 square feet with American Tire Distributors, each of which recently entered bankruptcy reorganization. All of these tenants are current on their rent, and in total, represent only 0.3% of our annual rent. These leases are also about 10% below market. If they were to vacate, we view it as a short-term pain for long-term gain similar to our hhgregg situation from last year. Let me now address revisions to our 2018 expected range of estimates, which is an exhibit at the back of our quarterly financial supplement available on our website. As we near the end of 2018, we have narrowed our guidance for core FFO to a range of $1.31 to $1.35 per share, which equates to an additional $0.01 per share increase at the midpoint. We have also increased our guidance for the range of growth in same-property net operating income to 4.2% to 4.8%, an increase of 0.5% at the midpoint. Revisions to certain other guidance factors can also be found in the Investor Relations section of our website. Finally, I want to address the upcoming change to lease accounting for 2019, specifically as it pertains to lessor's capitalization of internal leasing costs. This accounting change is expected to result in a $0.04 to $0.05 reduction to net income and to NAREIT-defined FFO in 2019. I know some companies are making changes to their compensation structure, solely to achieve more favorable accounting treatment. We will not be making changes to our compensation structure as a result of these new accounting rules as we believe it is more important to focus on what works for our business rather than the accounting consequences. Even though companies that use an outsourced model for their leasing function are able to achieve a better accounting treatment, we continue to believe our business model is more efficient and effective for a company of our scale. Last month, we posted a comprehensive packet of materials on our website with respect to this new lease accounting, including our proposed presentation for 2019 as it pertains to our core FFO definition, a definition that should optimize FFO comparability with other companies in our sector. We encourage everyone to review that disclosure. Now I will turn the call back over to Jim.

[James Connor:]

Thanks, Mark. In closing, everyone, I'll first note we're very, very pleased with our team's execution year-to-date on leasing performance, capital redeployment and development starts. As indicated earlier, we will closely monitor the macroeconomic and trade negotiation news. But for now, we're very optimistic about a solid finish for the remainder of the year. One last important transaction to announce. This month, we started construction on our new headquarters here in Indianapolis. As you may have seen from last month's press release, our new home will be LEED-certified Silver, four stories, 78,000 square foot office building containing advanced features to enhance team collaboration, connectivity and contribute to retaining an attractive top talent in the industry. In addition to those productivity benefits, the facility's LEED certification is a natural extension of our longstanding culture and long-term commitment to sustainability here at Duke Realty. I'm also pleased that our overall strong performance has allowed us to raise our quarterly dividend by 7.5%. Let me give you some additional perspective. Even with selling $5.6 billion of noncore assets between 2015 and 2017, we were able to raise our dividend by over 5% each year and maintained a conservative payout ratio. Going forward, we expect a more modest level of capital recycling each year tied to normal pruning of the portfolio and tied to modest shifting of our geographic locations further into Tier 1 markets, which significantly lessens potential earnings dilution going forward. With this dynamic substantially behind us and assuming the economy stays on sound footing, we're optimistic about our ability to grow our dividend in the mid- to high single-digit range for the foreseeable future, consistent with our potential growth in AFFO. We'll now open up the lines to the audience. [Operator Instructions]. Greg, you can now open up the lines, and we'll take our first question.

[Operator:]

[Operator Instructions]. And our first question comes from the line of Manny Korchman.

[Michael Bilerman:]

Actually, it's Michael Bilerman. I started to learn after 20 years that I have to unmute my line. I apologize. Mark, you talked a little bit about the ATM, that you raised $28 million in the quarter, and you put some context around it, keeps pricing pretty much in line with Street NAV, modest amount. I guess, I'm just stepping back and saying why raise at all when you have so much liquidity on the balance sheet and low leverage? And so if you can sort of help me understand that piece of it. And then if you had your drawdowns, how much would you have raised if the stock continued to move up?

[Mark Denien:]

Sure, Michael. I don't know that we would raise much more, even if the stock continued to move up. I mean, your points are valid. I mean, we don't need the money today. But our stock at that price, after you factor in the special dividend and the effect it had on our stock, there's only been 14 days in the prior two year period we traded at that level. And our development pipeline is very robust. So we think that come this time next year, we'll have uses for that money. But to answer your question, it's 0.2% of our outstanding share raise. It just wasn't a significant amount, and I don't know that we were to raise much more than that regardless of what our stock did.

[Michael Bilerman:]

And so you said I'll give you $60 million of capacity just to have done it at a price without much dilution.

[Mark Denien:]

I'm sorry. I didn't catch that, Michael.

[Michael Bilerman:]

No, I was just summarizing what you had said. Maybe if we can turn to the - just the development pipeline, that's the second question. You're sitting today with a 10.5 million square foot pipe, which is about 52% preleased, some chunky vacancies, the - and stuff in Indy, the bay assets in Atlanta, the big Southern California asset. Can you talk about what the preleasing is like right now on that remaining, call it, 5 million square feet to be leased? And when - how do you see that progressing over the next couple of quarters?

[James Connor:]

Sure, Michael. It's Jim. I just - I wanted you to know we really enjoyed your report last night, no diggity, no doubt. And my answer to your question is, "cover much ground, got game by the pound." For those of you who are not Dr. Dre enthusiasts, I'll translate. Actually, Michael, if you look in the back of our supplemental, the property that will be coming in service here in the fourth quarter, I'll just run through those. We've got a building in Cincinnati and another one following that in Minneapolis. We've got significant amount of activity there, both partial building tenants and full building tenants. So I'm not particularly worried about that. Chicago's got a bunch of activity. I would be surprised if that was around much longer. Atlanta's been a little bit streaky. The bigger building, the activity has been modest, I would say. The small building has got very strong activity. That one, I'm not particularly worried about. St. Louis has got reasonable activity. The California one that's coming due in the second quarter, the 657, it's a little early for that. We're just tilting panels. We've got a lot of activity on the Heacock asset, which is a little over 400,000 feet. I think, I'm pretty optimistic that will be gone in the fourth quarter. The smaller buildings in Indianapolis, again, those are multi-tenant type 2s. We've leased one of those already, and we've got good activity on that one. And then the New Jersey building, we're in negotiations to execute a lease for a little over half of that building. So as we've talked about, the only places where you've really seen some supply and a little bit of softness in the market is a little bit in kind of that I-80 corridor in Chicago. It's been a little soft. Some of the submarkets in Atlanta, particularly down south, have been a little soft, and then South Dallas, down by the intermodal had been a little soft. But by and large, consistent with the macro numbers that you're seeing, we've got really strong activity across the country.

[Operator:]

And next we turn to the line of Jeremy Metz.

[Robert Metz:]

I just wanted to stick with the development topic. You mentioned no real impact from tariffs. You said you're feeling optimistic on the pipeline, but tenants are obviously facing rising costs in other parts of their supply chain. Construction costs are rising. Just wondering what this all means from here in terms of the trajectory of the pipeline going forward. Based on 4Q deliveries versus what's left in your starts guidance, it does suggest the pipeline could shrink a little further from here. So just looking out, should we think about an active pipeline that's going to be slightly below today's level of, call it, $850 million?

[James Connor:]

Well, without giving 2019 guidance, which Mark is kicking me under the table, I would tell you that everything from the macro perspective to the conversations that we're having with our tenants feels like 2019 should be another pretty good year on the development side. Let me give you a couple of detailed points in terms of increased costs. And we've talked about this before. You've got to remember that real estate cost is a fairly small component of the overall logistics and supply chain, literally 4% or 5%. So while prices have been going up and everybody wants to pay attention to the bottom line, the cost of transportation and the cost of labor are a much more significant factor for our clients. The other thing I would tell you is, as our clients are trying to get more efficiency out of the supply chain, the bigger buildings, the higher clear height allow our clients do that. So in a lot of instances, you'll see clients consolidate into larger facilities because they can operate those more efficiently, and that's how they squeeze more savings out of the supply chain.

[Robert Metz:]

But sticking with that point you just made, is there - if tenants facing significant increases on transportation and labor, is this at all - are you seeing anything on the ground where this is starting to eat in your ability to keep pushing the rents you have?

[James Connor:]

No. I think, as demonstrated by the rent growth numbers we've put up this quarter, we're not seeing any of that. And quite candidly, I don't know what a client's alternative would be in terms of - I suppose, they could go to a third-tier market and get less expensive space. But today, it's all about having product that's close to the population and the end consumers as possible.

[Operator:]

And next we turn to the line of John Guinee.

[John Guinee:]

Great. Mark, you gave a carefully crafted explanation of what looks like about a $15 million to $18 million of lease costs, which are now going to be expensed versus capitalized. Do you basically say that you're going to back that number out of NAREIT-defined FFO to get to core FFO?

[Mark Denien:]

That's right, John. Yes, and we've got an exhibit that we put out on our web about I want to say a month or so ago, and we'll update that shortly here with third quarter numbers, but I think the trend is pretty accurate with what's - what we posted. I think we went through a rationale on why that is, and we believe it just makes it more comparable. We could go outsource those functions and pay more money and get better accounting, but it just doesn't make sense for our business to do it that way. So this is a way to be comparable.

[Operator:]

And next we turn to the line of Blaine Heck.

[Blaine Heck:]

So you touched on this a little bit, but this quarter's acquisitions and dispositions were pretty light with nothing on the acquisitions side, just one small disposition. Maybe for Nick, can you just talk a little bit more about the investment sales market and cap rates and whether the acquisition market has gotten more difficult recently? Or are you guys just taking a pause or just finding other avenues for investment that are more favorable at this point?

[Nicholas Anthony:]

Well, first of all, our activity was anticipated to be more modest anyway this year and going forward. Definitely, the cap rate environment is frothy is the way I would put it. We haven't seen any expansion cap rates. And we are very focused on high-barrier Tier 1 markets where we can't already develop in. We do - we are still seeing opportunities though. We've looked at a lot of different projects and still think we'll be able to recycle some of our dispositions into these high-barrier tier markets on a go-forward basis.

[Blaine Heck:]

All right. That's helpful. And then, Mark, clearly you guys have established a fortress balance sheet and very low leverage, given all the proceeds you guys have been churning through. But can you just talk about whether you have a longer-term target for debt-to-EBITDA? And how do you think about balancing kind of the safety of a good balance sheet versus a little bit more FFO growth with more leverage?

[Mark Denien:]

Sure, Blaine. Yes, I mean, we're in the upper 4s, like 4.8, 4.9 now on debt-to-EBITDA. I think our longer-term goal is to be more in the mid-5s, which gives us plenty of dry powder to get from where we are to today up to that mid-5s. But we also want to have flexibility to - as long as - we don't know where we are in the cycle, but we're closer to the end than we were a month ago and a year ago and two years ago. So we do like that flexibility. And like I said earlier, we do have a very strong development pipeline. And like Jim said, we're not giving guidance for '19, but '19 to us right now looks pretty good. So having a little bit of extra cash on the balance sheet right now, I think you'll see that put to use, quite honestly, probably by year-end. I think all of the cash will be fully redeployed by year-end, and then we'll be off and running next year.

[Operator:]

And we have a question from the line of Eric Frankel.

[Eric Frankel:]

Jim, I know you're trying to make a big push into the West Coast, I didn't realize that your musical taste extended there, too. Quick question, just going back to development. Obviously, you guys are - your - I think one of your core competencies is your ability to procure build-to-suit business. And you established a risk parameter of just having a certain amount of your development pipeline being preleased. Has that precluded, though, the opportunity to start or identify any attractive, speculative development opportunities. So is there another way maybe of rethinking your - the risk parameters regarding developments? Are there - maybe there's more speculative development upside?

[James Connor:]

Yes, Eric. We actually talk about that quite a bit and we've been - our teams have been performing really well. So we've been able to garner enough build-to-suit business to keep us above 50%. We've kind of fluctuated between the low 50s and maybe low 60s, and that's really just kind of driven by the timing of starts in different markets. This quarter's development activity was about 51%. We have dipped below 50% in the last few years. I like to give everybody a little bit of notice when we're going to do that. And again, it's generally driven by timing. So we could go down into the mid- or upper 40s if we started a couple more spec buildings, but we still felt comfortable about the development pipeline. But you're not going to see us have a significant change in strategy and shift the vast majority of our development activities back like some of our peers do. I think we remember what 2008, '09 and '10 were like and are very comfortable with the risk profile that we have with our development pipeline, and it's a substantial development pipeline. So we feel pretty comfortable where it is. It could come down a little bit more as we start some more projects in early 2019.

[Eric Frankel:]

Okay. I appreciate the response. Just a quick follow-up question, I'll jump back in the queue. Maybe it's a question for Nick. But obviously, it's certainly understandable that cap rates are pretty firm everywhere, if not compressed a little bit. Maybe you could talk across markets where you think cap rates have - might have compressed more than others. Is it coastal markets? Is it noncoastal markets? And does that affect your acquisition and disposition strategy?

[Nicholas Anthony:]

Yes, they definitely compressed in the high-barrier Tier 1s

[Operator:]

And next we turn to the line of Nick Yulico.

[Nicholas Yulico:]

Just first on supply. If I look at some of the top markets where - of yours where supply growth looks like it could be more meaningful in the next couple of years, it's Dallas, Atlanta, Houston, even Indianapolis. Can you just give us an update there on whether - and this is based on your sort of overall market level supply. How are you thinking about those markets and where your portfolio is positioned versus some of the supplies that's coming into those markets?

[James Connor:]

Yes, Nick. We look at all the same data you do, and we've got people on the ground. So we think we've got pretty good tabs on that. And I think what's important to remember is it tends to be submarket by submarket, and Dallas is a great example. The softness in Dallas is primarily South Dallas, down by the intermodal. There's a number of large spec buildings down there. There's no shortage of land, yet if you go up by DFW in the North Airport market, vacancy is under 4%. So it's kind of a Tale of Two Cities, and you'll see that pretty consistently around the system. If you go to Chicago, we're building a small spec building, which is up in DuPage County close to O'Hare. And there's not a lot of product available there. It's really an infill redevelopment play to take advantage of the airport. And the softness in Chicago tends to be way south down in the I-80 corridor in the bigger buildings. So we're very attuned submarket to submarket about what's going on and trying to keep our eyes on that on a pretty consistent basis.

[Nicholas Yulico:]

Okay. And then how would you characterize Atlanta?

[James Connor:]

I would characterize Atlanta the same way. I think you've got some softness in the market down south, but I think in some of the more core markets, I think things look fine. We've got, I think, three buildings down there under construction, one small one and a couple of midsized ones. So I think, for the most part, we're pretty comfortable with the amount of activity that we've got down there. That having been said, I don't think you'll see us teeing up another building until we get some leasing done on a couple of those.

[Nicholas Yulico:]

Okay, that's helpful. Just one last one on occupancy. I recognize you have occupancy upside in your nonstabilized pool, but same-store occupancy is now at a pretty high level, higher-than-normal level. It seems like that was the driver of the increase to the same-store guidance. How should we think about same-store NOI growth next year being impacted by what looks like high occupancy today? Does that create tough comps for you next year? And how are you sort of viewing the trade-off between keeping high occupancy versus maybe pushing rents more and having some more frictional vacancy?

[James Connor:]

Well, Nick, I would say that 99% current quarter comp is probably pretty tough, not much you can go above that. But we're happy with that. I mean, I suppose - with 100%, we'd be 1% happier than we are. But the way we look at it, collecting cash earlier than later is not a bad thing. I don't know that you can really look at it and say we're not pushing rent growth enough. I think compared to all of our peers, I think our results on rent growth, whether it be on a GAAP or cash basis, stack up very well, if not maybe top of the class. So it's harder than, I think, pointing fingers, and say we're not pushing rents enough. There's no doubt that 99% same-property occupancy will be a tough comp, but we'll take the cash at the end. If we can keep it at 99% next year, that's a good thing.

[Operator:]

And next we turn to the line of Dave Rodgers.

[David Rodgers:]

Jim, just wanted to ask quickly maybe about the move to Tier 1 markets. Obviously, it's been happening for a while. Do you see, I mean, an ability to accelerate that? Or do you look at it out the next couple of years and say, "Hey, it's going to be a $600 million to $800 million move as we move forward"? And maybe the second part of that question is, what dilution are you willing to accept on kind of a current basis? And are those market excess portfolio sales? And is there a more strategic way that you're thinking about that over the next couple of years?

[James Connor:]

Thanks, Dave. Well, let me answer the second one first, I think, and then I think that'll lead me into the answer to the first part. When we got done with the medical office disposition and redeploying the bulk of those proceeds, we started to tell everybody that our disposition was going to be much more modest going forward. I think we'll be in the $500 million range this year, but we basically said we ought to be between $200 million and $400 million going forward, which allows us to be good stewards of the portfolio and continue to prune and continue to try and affect the appropriate geographic shift that we want to do. But most of the growth is really - have come through development and through some acquisitions. As Nick said, we haven't completely closed up the acquisition shop. We're out looking at deals, whether it's value-add, redevelopment, covered land plays and some core acquisitions in these Tier 1 high-barrier markets. That's how we're going to supplement our growth beyond what we're able to do with the development. And again, we talked - we're not giving guidance for '19. But if everything is pretty consistent with what it's been here for the last couple of years, I think we would look to do a comparable level of development. If we found the opportunity to accelerate development in those Tier 1 markets beyond the kind of levels we've been running at the last couple of years, we always have the ability to accelerate dispositions. We've always got a pretty accurate pending list of dispositions that's 2 to 3 years out. So we could always bring forward a play or an asset that we want and realize those proceeds and redeploy that into development if we find some great development opportunities.

[David Rodgers:]

And do you think from this point, just kind of looking where you're at for 2018, say FFO guidance, absorbing that dilution, you feel like you can keep that rate of growth going. It sounds like based on your earlier comments on the call, it's not a little stronger.

[James Connor:]

Yes, absolutely. Yes, I mean, look, once - we've told everybody, once we got down with this massive 7-year repositioning of the company, it's now time for us to put our head down and grow, and that's what we're really focused on doing. So minimize dispositions, use acquisitions to supplement our Tier 1 growth and focus on development, which is, a, what we're good at, and we're creating a tremendous amount of value for our stakeholders today as opposed to what we're seeing at acquisitions.

[Nicholas Anthony:]

And keep in mind, on the dispositions side, we're seeing very good pricing there as well. So that will help manage the dilution going forward.

[Operator:]

And next we turn to the line of Jamie Feldman.

[James Feldman:]

I know in your remarks, you had mentioned you're really not seeing any kind of slowdown from trade wars or tariffs, but are you seeing any regional shifts in demand? Are customers more comfortable with signing longer-term leases in certain markets than others as you think about the activity you've seen?

[James Connor:]

No, Jamie, not really. It's funny when we talk to our major national customers who are redoing components or their entire supply chain, it's not driven necessarily by their geographic demand. A lot of it is driven by where they own facilities, where they lease facilities, what leases are coming up. And their play is we'll get the whole thing done, but we're going to deal with these assets in this market first or it's - the other side of it is it's driven by demand. And so you may see a national customer start with a build-to-suit in Columbus, Ohio and then go to New Jersey and then go to Atlanta. So I can't tell you that we're seeing any customers telling us that they've got increased demand, and that's changing their focus from a geographic perspective other than what I reiterated earlier, which is the key philosophy of most of our customers is the need to get this product as close to the major population areas and their end consumers as possible. And we're continuing to see that trend. And companies can afford to spend significantly more in rent because rent is a much smaller percentage of the supply chain costs if it gets them closer to the customers and help them save on transportation.

[James Feldman:]

Okay, that's helpful. And then can you take a crack at where you think your mark-to-market is on the portfolio?

[Mark Denien:]

Jamie, I would tell you the lease is rolling in the next 18 months, which, like we always say, that's kind of how far out we look. We think the rent growth is going to look a lot like it has this year. I think it's going to be plus or minus low 20 percents on a GAAP basis and high single digits, maybe pushing low double digits on a cash basis based on what we have coming over the next 18 months. You've got to keep in mind, our portfolio, we've got a lot less rolling each year than a lot of our peers because we have a lot longer lease terms. So we just don't find it useful to figure out what our mark-to-market is on a lease that's rolling nine years from now. But we do look out over the next 18 to 24 months, and I think it looks pretty similar to what we're seeing today.

[James Connor:]

Yes. I think the other point I would make is we've been lucky, and that's probably the result of a lot of hard work by our teams, that we have not been negatively impacted by any of these major bankruptcies. But anytime we get these spaces back, what we're finding is they're below market rents. And while we've got a short downtime of generally four to maybe as much as eight months, depending on the market and the submarket, we're improving rents. We improved rents over 10% on those hhgreggs. And if we get any of these minor spaces back from Sears or Mattress Firm or the tire guys, we're looking at probably north of 10%. And I think that's a pretty good sign about the strength of the markets that we're seeing all over the country.

[James Feldman:]

Okay, and if I could just clarify one thing you said before. You said 2019 will be another good year on development. Is it safe to assume that means the pipe starts would be at least as large as '18?

[James Connor:]

Jamie, without getting kicked really hard under the table that - I'm going to stick by my earlier comment that 2019 looks really good.

[Operator:]

And we have a question from the line of Michael Carroll.

[Michael Carroll:]

Yes. Just kind of real quick on the development activity and the near-term starts. Can you kind of highlight where those starts are going to come from? Is it going to be more of the core coastal markets, the Tier 1 markets you kind of want to grow into? I guess, what percentage of the starts will that represent?

[James Connor:]

Well, I think we were just looking at this the other day, Mike. I think Tier 1 starts represent about 60% of our development activity. And while we don't have a clearly defined target, we do have a priority to put money out into those Tier 1 markets in both build-to-suits and spec development. So I think you could - the conclusion you could draw is it would probably be pretty consistent with that. And had we the opportunity to create value and accelerate that to a higher number, I think we'd probably do that.

[Michael Carroll:]

Okay. And then how are development yields different from those Tier 1 markets versus the, I guess, more of the general inland-type markets? Is it a big difference?

[James Connor:]

Yes. It's a pretty widespread, but what it really is, and Nick can give you the detail, is it's a function of the spread over the cap rates. And so as we've continued to see cap rate compression, we've seen our going-in yields go down. But what we're really focused on is the value creation of the margins. And we've consistently been developing for the last few years, maybe as much as five years, in the 20-plus percent range on our entire development pipeline. And we're consistently being able to hold those margins because of the cap rate compression.

[Nicholas Anthony:]

Yes, and I would say, in the Tier 1s, we've actually experienced a lot of rent growth and cap rate compression after we tied up the lands. So the margins have actually done better.

[Mark Denien:]

Yes. Yes, Michael, and I'll add a couple of more points as well. I think the margins in our Tier 1 markets are actually a little bit better than our, I'll call it, our non-Tier 1 markets, partly because the non-Tier 1 markets have more build-to-suits in them as well. So when you look at places like Cincinnati and Columbus, Ohio, that's a lot of where build-to-suits are coming from. So you get a little bit lower margin, but obviously a lot lower risk as well. So we have higher margins in those Tier 1 markets, even though the yields are lower. And to Nick's point, keep in mind, we stay - the way we do our margins that we put in our supplemental, it's we underwrite based on today's rent, and we always assume a 12-month lease-up period. If you'll go back and you look at the last two years' worth of starts that have now been stabilized, we've actually beat our stabilized yields by about 25 basis points because by the time they went in servicing, got leased, rents had increased. Yet like I say, we underwrite based on today's rent, and we've been able to lease it in less than a year. So we have less carrying costs. So if you look at the 2016 and '17 starts, they closed out about a 25 basis point increase in yields from what we had in our supplemental, which equates to about an extra 5% margin than what we had in our supplemental.

[Operator:]

And next we turn to the line of Ki Bin Kim.

[Ki Bin Kim:]

So the 28% lease spread you guys posted this quarter really high number obviously. Where is that mostly coming from? Is it broad based? Or are there just certain markets that are pulling above their weight?

[James Connor:]

No, Ki Bin. I'm telling you, it's pretty broad-based. If there were any standouts plus or - positive or negative, I'd tell you we have cited that in the past when we did a particularly ugly renewal or something like that and it brought the number down. But no, this is - as you had said, it's pretty broad-based across all markets. And I think back to the vacancy numbers we cited, when you've got an average 4.3% vacancy, it gives us a lot of leverage in the marketplace.

[Ki Bin Kim:]

And this still might be a little bit too early, but you have a couple of major e-commerce players in your top 10 list who, I guess, shall remain unnamed. Any of these kind of first-generation leases, have you done any renewals on them lately? Or there's still too many years left in the leases. I was just curious, like how the negotiations would proceed with some of the bigger players.

[James Connor:]

Yes. We have negotiated renewals on a number of those, and we have some in process right now. And I would tell you they're fine. They're not - it's not - we still have the same leverage. And one of the things I would tell you about our e-commerce clients who are very, very focused on growth, the truth is they're so focused on getting more space into production. They don't really have much interest in giving up space. So unless it's really nonstrategic for them, and they make huge, huge capital investments in these buildings, a lot of material handling, equipment and everything else. So it's really not - it's got to be a situation where it really doesn't work. So I think you'll continue to see us have very good success renewing these major tenants, particularly the e-commerce ones that are growing consistently around the country.

[Operator:]

Next we turn to the line of Tom Catherwood.

[William Catherwood:]

So sticking on the Tier 1 development topic, you guys have kind of 1,250 acres available for development and another 550 with purchase options, but you've always talked about how this is the type of land you can put into production pretty quickly. When we think of the Bridge Portfolio, some of those assets, just great locations, but some of those locations took years, if not a decade, to assemble and title and get into production. As you move more into these Tier 1 markets and want to do more development, what are your thoughts on switching to portion of the land bank being kind of more longer-term land for you to work through entitlements on versus what you can put on production right away?

[James Connor:]

Well, Tom, yes, you're absolutely right. Anytime you're doing Tier 1 infill redevelopment, it tends to be very complicated, and that adds time to the process. What we look at is the amount of land that we can carry. We've kind of targeted between 300 million and 400 million. And we can make a certain amount of plays that are more long term in nature. And then in other instances, we can't. We've got to keep a defined balance. So most of the projects that we're working on today have a, I would tell you, a 9 to maybe 18 month time line, and we find that we're very competitive with those, and we can put those into production. But making a big investment in a substantial site that's going to take 5 or 10 years to entitle is probably not in our sweet spot, unless you've got a situation where the landowner is willing to carry the land. But for us to buy and take the development risk and carry it for that long, that doesn't really work for our equation right now.

[William Catherwood:]

Got you. And has that kind of 9 to 18 month time line extended at all relative to Tier 1? Or is that pretty consistent with what it's been for the past few years?

[James Connor:]

They're really all over the board. Most of the infill Tier 1s that have - whether you're talking about a blighted site or have some environmental contamination that needs to be cleaned up, you have great cooperation from the municipality. So that's not the delay. The delay is taking it through the process and getting the clean-up done. In other areas where you're working through the entitlement process and the permitting process, which is, in some of those markets, much more intensive and much more lengthy, that's the challenge. So we see them all across the board. And then you have a setback every once in a while in terms of not getting a certain approval and having to go back and start over and getting some delays. That's the nature of the brownfield redevelopment business. But by and large, that's a pretty good range, and anything outside of 18 months is going to be pretty problematic for us to carry.

[Operator:]

And next we turn to the line of Eric Frankel.

[Eric Frankel:]

Just one quick follow-up. I was - maybe you could explain the leasing dynamic that explains the same-store NOI growth guidance increase. Were there any particular markets where you - where rents were growing a little bit faster pace than you expected? Apologies if you didn't - if you've already explained that earlier.

[Mark Denien:]

So Eric, I don't think there is any really markets per se. I think just overall, rent growth across the board is a little bit better than what we had expected. I think this was our best quarter all year and we got really better every quarter as we went through the year. So I think it's just really across the board, and it's overall better rent growth. And I would tell you the other thing is quicker backfill of expiring spaces. We have certain tenants that we are pretty certain are going to vacate, and we were right, they vacated. What we didn't count on was having a tenant ready to take that space the day they left. I mean, almost literally, the day they left, ready to come in. So while our renewal rate was high at 82% for the quarter, if you look at the amount of space that was backfilled the same quarter, it was like 95%. We certainly didn't budget or project that to happen. So it's really just a combination of better rent growth across the board and just the sheer demand for space and the backfill of these expiring tenants happening quicker than we thought.

[Operator:]

And next we turn to the line of Manny Korchman.

[Michael Bilerman:]

It's Michael Bilerman, again. Jim, I just wanted to ask you about scale. How much do you think you need additional scale to be effective? You've clearly seen Prologis after the DCT merger jumped up pretty significantly. Blackstone's, obviously, made a massive play, redoubling their efforts on their industrial platform. Global Logistics had to stop theirs. So where do you sort of see yourselves from a scale perspective overall?

[James Connor:]

Well, that's a great question. We believe there are advantages to scale in our business, which is one of the reasons we've continued to grow. Second largest in the sector and largest pure-play industrial U.S.-only REIT. We love to continue to grow, and I think we look at every opportunity. And if we think an opportunity presents itself and we can improve our FFO and our AFFO, and we look at NAV and we're comfortable what that does, and we can grow the organization, we like those kind of opportunities. I think the situation you're seeing today is everything is very, very expensive. And even the deals that are getting done are probably right on the edge from a value-creation perspective. So we'll continue to look. As Mark alluded to earlier, one of the reasons we've tried to keep some dry powder is, given where we are in the cycle, I think there may be some even better opportunities in the future, and I'd like to have the flexibility to take advantage of those.

[Michael Bilerman:]

Well, I guess, how do you think about using your equity, which is post to where you just issued that small amount using your equity in a M&A transaction, whether that's public to public or one of the numerous private large portfolios that's out there, how does that play into the desire for scale? How do you sort of balance those things with the cost of capital that may be very attractive?

[James Connor:]

Yes. I mean, that's one of the tools in our toolbox. And look, we like our price. I liked it a little better when Mark was issuing equity a couple of months ago, but we're in a very strong performing sector. And our stock price has continued to do well, and that's a tool that we can use in certain instances where it makes sense. So we're not opposed to using equity or leverage or a combination of both to go out, again, if we can find an opportunity that's going to create value.

[Michael Bilerman:]

And just the last thing. If you think about the Prologis-DCT merger, a lot of the synergies came from two things. One was eliminating the $30 million of G&A immediately and then basically refinancing the entirety of DCT's debt book with international, current international drawdowns. There's future synergies on the comp, but that was immediate cash uplift that they were able to get, whereas the pricing of the real estate clearly was at or above market. So how do you separate those things in your underwriting, valuing the real estate versus valuing the cash flow potential from basically cost synergies?

[James Connor:]

Well, you've hit on the key components. The only way you can justify paying somebody the prices that you have to pay today at or clearly above replacement cost at the absolute top of the market is if you can gain significant operating efficiencies. We've got a national footprint. We think that opportunity presents itself, but you've got to look at every one of those on a case-by-case basis. And they don't necessarily all line up perfectly. I think that the transaction you've referenced, that was clearly the main impetus. But the other part of it is keeping and maintaining some sort of the culture of the company you buy because that factors into the situation with the seller, because there are a whole lot of willing sellers right now. So it's got to be a balance, but you've got to be able to go out and create enough synergies to be able to save enough money to justify paying the premium.

[Operator:]

Next we turn to the line of Michael Mueller.

[Michael Mueller:]

Yes. A quick question on the GAAP spreads again. Looking at the 25% year-to-date number, can you walk through just some of the factors that are helping you get there? You obviously have the actual cash spread. Looks like the duration on the new leases is about five years. How different is that from what's being replaced? And the same with bumps, what sort of bumps are in the new leases versus the old leases?

[Nicholas Anthony:]

I would tell you the tenor of the leases tend to be the new lease is a little short, generally, than the old because some of these are 10- and 15-year original lease terms that were development and the typical renewal is 5 years, as you just said. So there's a little bit of a roll-down in the term of the new deal compared to the old deal, not significant but a little. Most of it is just good old-fashioned real rent growth. And the other piece is the bumps are growing. We are at about 2.25% to 2.4% in our total portfolio right now. But about every deal we're doing today is at 3%, or in some cases, even more bump. So that means the old - some of the old leases that are rolling were 1.5%. So you're seeing the old lease go from a bump of probably 1.5% to maybe 2% was a good bump and then the new lease is 3%. So the bumps are about double.

[Operator:]

[Operator Instructions]. Next we turn to the line of John Guinee.

[John Guinee:]

Great. Just to help me on, Mark, or help us all out. Based on your sources and uses, when do you think you'd need to tap the equity markets again?

[Mark Denien:]

When do we need to tap the equity markets again? It won't...

[John Guinee:]

Say at 5.5 net debt-to-EBITDA.

[Mark Denien:]

It won't be 2019. It'll be beyond that. And a lot will depend on development that we'll give guidance on beginning next year. But I can tell you, whatever that guidance is, John, we will not need to tap the equity markets in 2019.

[Ronald Hubbard:]

I'd like to thank everyone for joining the call today, and we look forward to reconvening again during our fourth quarter call, scheduled for the same time on Thursday, January 31, 2019. Thanks, again.

[Operator:]

And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T Executive TeleConference Service. You may now disconnect.