Eastgroup Properties Inc Q4 FY2021 Earnings Call

Good day and welcome to the EastGroup Properties Fourth Quarter 2021 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Marshall Loeb, President and CEO. Please go ahead.

Good morning, and thanks for calling in for our fourth-quarter 2021 conference call. As always, we appreciate your interest. Brent Wood, our CFO, is also participating on the call. Since we'll make forward-looking statements, we ask that you listen to the following disclaimer.

Please note that our conference call today will contain financial measures such as PNOI and FFO that are non-GAAP measures as defined in Regulation G. Please refer to our most recent financial supplement and to our earnings press release, both available on the Investor page of our website. And to our periodic reports furnished or filed with the SEC, for definitions and further information regarding our use of these non-GAAP financial measures and a reconciliation of them to our GAAP results. Please also note that some statements during this call are forward-looking statements as defined in and within the Safe Harbors under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Private Securities Litigation Reform Act of 1995. Forward-looking statements in the earnings press release, along with our remarks are made as of today, and we undertake no duty to update them, whether as a result of new information, future, or actual events, or otherwise. Such statements involve known and unknown risks, uncertainties, and other factors, including those directly and indirectly related to the outbreak of the ongoing coronavirus pandemic that may cause actual results to differ materially. We refer to certain of these risks in our SEC filings.

Good morning and thank you for your time. I'll start by thanking our team for a great quarter and year. They are continuing to perform at a high level and capitalizing on a very positive environment. Our fourth-quarter results were strong and demonstrate the quality of our portfolio and the strength of the industrial market. Some of the results the team produced include funds from operations coming in above guidance up 17% for the quarter, and 13% for the year well ahead of our initial forecast. This marks 35 consecutive quarters of higher FFO per share as compared to the prior year quarter, truly a long-term trend. Our quarterly occupancy averaged 97.3% up 40 basis points from fourth quarter 2020 and at year-end we're ahead of projections at 98.7% leased and 97.4% occupied. Our occupancy is benefiting from a healthy market with accelerating e-commerce and last-mile delivery trends. Quarterly releasing spreads were 31.5% GAAP and 18% cash. Similarly, for the year those results were at a record pace of 31.2% GAAP and 18.4% cash. And finally, cash same-store NOI rose a healthy 6.4% for the quarter and 5.7% for the full year. In summary, I'm proud of our team's results creating arguably the best year in our history. So now on to 2022. Today, we're responding to strengthen the market and demand for industrial product by both users and investors by focusing on value creation via development and value-add investments. I'm grateful we ended the quarter at 98.7% leased, one of our highest quarters on record. And to demonstrate the market strength, our last five quarters marked the highest five-quarterly rates in the company's history.

Looking at Houston, we're 95.9% leased and Houston is projected to represent under 11% of 2022's NOI total, falling 130 basis points from 2021. I'm happy to finish the quarter at $1.62 per share in FFO and the year at $6.09 per share, up $0.06 from our most recent annual guidance. Helping us achieve these results is thankfully having the most diversified rent roll in our sector with the top 10 tenants only accounting for 7.6% of rents. Brent will speak to our 2022 guidance, which I'm pleased is to a midpoint of $6.63 per share, up roughly 9% from 2020 once record level. As we've stated before, our development starts are pulled by market demand. Based on the market strength we're seeing, we're forecasting 2022 starts of $250 million. We plan to closely monitor leasing results along the way and expect to update our starts guidance throughout the year. To position us for this market demand, we've acquired several new sites with more in our pipeline along with value-add and direct investments. More details to follow as we close on each of these opportunities. Brent will now review a variety of financial topics, including our 2021 results and introduce our 2022 guidance.

Good morning. Our fourth-quarter results reflect the terrific execution of our team, strong overall performance of our portfolio, and the continued success of our time-tested strategy, FFO per share for the fourth quarter exceeded our guidance range at $1.62 per share. And compared to fourth quarter 2020 of $1.38 represented an increase of 17.4%. The outperformance continues to be driven by our operating portfolio performing better than anticipated, particularly, occupancy and rental rate growth. From a capital perspective, during the fourth quarter, we issued $120 million of equity at an average price of $205 per share. And in October, we repaid a maturing $33 million mortgage loan that had a rate of 4.1%. After year-end, we agreed to terms on the private placement of $150 million of senior unsecured notes with a fixed interest rate of 3.03% and a 10-year term. We expect to issue and fund these notes in April. Also after year-end, we agreed to terms on a $100 million senior unsecured term loan with a total effective fixed interest rate of 3.06% and six and a half-year term. The loan is expected to close on March 31st. That activity combined with our already strong and conservative balance sheet has kept us in a position of financial strength flexibility. Our debt to total market capitalization was a record low 13%. And for the year, our debt-to-EBITDA ratio finished at 5.2 times, and our interest and fixed charge coverage ratio was 8.5 times. Our rent collections have been equally strong. Bad debt for the year was a net positive $475,000, as tenants whose balances were previously reserved came current exceeding new tenant reserves. This trend continues to exemplify the stability, credit strength, and diversity of our tenant base. The dynamic growth of our earnings, as well as exhausting the prior tax accounting change benefit, pushed us to increase the dividend for a second time during the year from $0.90 to $1.10 per share. An increase of 22%. We anticipate that the rate of our dividend increase will normalize in 2022. Looking forward, FFO guidance for the first quarter of 2022 is estimated to be in the range of $1.59 to $1.65 per share and $6.56 to $6.70 per share for the year. 2022 FFO per share midpoint represents a 9% increase over 2021. Among the notable assumptions that comprise our 2022 guidance include an average occupancy midpoint of 97%, cash same property midpoint of 5.6%, bad debt of $1.5 million, operating and value-add acquisitions of $76 million, offset by $70 million in dispositions, issuing $375 million in unsecured debt, which will be offset by $75 million of debt repayment, and common stock issuances of $120 million. As Marshall mentioned, our projected development starts are $250 million, which is down from $341 million in 2021. However, recall that last year's amount includes $90 million for a large build-a-suit in San Diego. Our 2022 start guidance does not include any unknown build-a-suits that might occur through the course of the year. In summary, we are very pleased with our record-setting 2021 results. As we turn the page to 2022, we will continue to rely on our financial strength, the experience of our team, and the quality and location of our portfolio to maintain our momentum. Now, Marshall will make some final comments.

Thanks, Brent. And closing. I'm excited about the year we just completed. We are now carrying that momentum into 2022. Our company, our team, and our strategy are working well as evidenced by the results posted. And it's the future that has me excited for EastGroup. Our strategy has worked well the past few years and now we're seeing an acceleration in a number of positive trends for our properties and within our markets. Meanwhile, our traditional tenants remain and will continue needing last-mile distribution space and fast-growing Sunbelt markets. These along with the mix of our team, our operating strategy, and our market has us optimistic about the future. And now we'd like to open up the floor for questions.

We will now begin the question and answer session. If you're using a speakerphone, please pick up your handset before pressing the keys. Please limit yourself to one question and one follow-up. If you have further questions, you may re-enter the question queue. At this time, we'll pause momentarily to assemble our roster. Our first question comes from Alexander Goldfarb from Piper Sandler. Please go ahead.

Hey. Good morning down there. So first question is on the supply chain. Now we have truckers part of the headlines but between the ports, factories trying to catch up with orders, plus shipping and all this stuff. What are your accounts saying as far as when they see the normalization of the supply chain because obviously, it's been great for you guys for demand and certainly the adjusting case type conversion on distribution thoughts. So just trying to see how much longer you guys think that will be in this tight supply market?

Hey Alex, good morning. It's Marshall. I want to start on a positive note. We have about 1,600 tenants, which contribute just over 7.5% to our NOI, a relatively low figure. There’s a diverse range of tenants in the mix. In terms of the supply chain, I think we have a variety of responses. You mentioned truckers, backlogs, support issues, as well as warehouse workers and closures due to hiring shortages. Overall, it seems most of our tenants believe that demand is strong right now and are optimistic about their businesses. However, from our experience with ordering building materials and working with our tenants, it's likely that we'll experience supply chain challenges throughout 2022. While there might be some improvements, the situation will still be complicated. A factor that may assist overall industrial rates is the shift towards maintaining safety stock or additional inventory. Many tenants are eager to do this, but I’ve heard it described as somewhat of a pipe dream. In reality, most tenants are focusing on meeting current demand instead of preparing for future demand. Inventory to sales ratios remain historically low, which suggests there’s still a lot of work to be done. The good news is that we’re nearly at full capacity, we’re increasing rental rates, and it’s challenging to deliver new products. Tenants are actively seeking to boost their inventory. As we plan for this year, we’ll remain adaptable, but we anticipate that demand will exceed supply, leading to ongoing efforts to keep up with growing demand, which probably won’t change until next year.

Okay. As a follow-up to that, Marshall, every year you mention getting lucky the previous year. Last year was exceptional, and this year looks challenging. I’ve lost count of how many years you’ve experienced growth. The narrative you’re presenting remains quite similar to last year: there is strong demand, the external environment is tough, yet you seem to manage well. It appears there has been no resistance on pricing, and the capital markets are favorable for financing. What genuinely concerns you, considering you’re at 97% capacity? It might be harder to surpass that, but Brent pointed out the dividend returning to a normalized growth level, and everything described in this call suggests a continuing robust and remarkably superior growth environment.

I wanted to ask a question that reflects either management's approach or my cautious nature. It's been a while since I visited a casino, and I admit to being somewhat conservative. I hope you can say later in 2022 that our caution was justified. We're currently at 97% average occupancy, and if we meet our budget, it would mark the company's second best year, just slightly below last year's 97.1%. I'm hopeful we can improve on rent increases, but that will likely benefit 2024 and beyond, depending on the timing of lease expirations. This year, I'm more concerned about the external environment. The supply chain issues and market tightness play a significant role. If we can stay ahead of these challenges, I'm noticing increased interest in our development projects earlier than expected. Generally, activity picks up once we start making progress on spec developments. Despite the competitive nature of the market for acquiring quality industrial properties, we're open to finding good opportunities but are also prepared to wait if nothing sensible presents itself.

Okay. Thank you.

You're welcome.

Good morning, guys, and congrats on another good year. Just following up on the external front, Marshall, you bought a piece of property in San Diego, the CME per Veeva value-add deal, 65% leased. Why would a developer sell this given how strong the leasing market is, and what opportunities do you see out there to do more of these types of transactions?

Good morning, Elvis, and thanks. Regarding Siempre Viva, we have Siempre Viva I and II from separate transactions. Earlier this year, we had 40 acres where we planned to develop a business park, but then Amazon expressed interest in acquiring the entire 40 acres for their Speed Distribution Center, which is currently under construction and is expected to be delivered by the end of the first quarter. Since then, we have been exploring additional land for opportunities or value-added projects that have vacancies. Without naming them, there is a large pension plan involved that reached the end of its investment period while still owning buildings in this park and submarket. Despite having a significant tenant of 250,000 square feet go bankrupt, they made a good profit on their investment. This site is very close to the Mexico border, where a new high-speed border crossing is being built. We are located between two border crossings, which is beneficial. The same local developers who built this park are involved. Despite the recent vacancy, the pension fund had a strong performance overall. During our due diligence, the property was 50% leased, and we managed to secure a 3PL tenant, bringing it up to 65% leased today with strong interest. I see this as an assembly line process; we will complete this project and look for the next opportunity in San Diego. We appreciate the proximity to the border, as long-term trends may indicate more near-shoring for manufacturing from China to Mexico. Additionally, San Diego is shifting towards life science and creative office spaces, which is pushing traditional industrial users further towards the border. We are optimistic about the geographic dynamics in this area. I hope this provides a clearer picture.

Thank you. And maybe one from Brent. What's the impact from higher borrowing rates that you're seeing today relative to 2021 in the future, how should we be thinking about capital allocation with rising rates for EastGroup? Thank you.

Yes. Good morning, Elvis. We're closely monitoring the situation. Earlier this year, we acted swiftly to secure $250 million through two loans, locking in just over 3%, which we were quite pleased with. This should provide some insulation for us in the early part of the year. Additionally, we only have one mortgage maturing soon, at the end of this month, which carries a rate exceeding 4%. We are paying off this higher-rate mortgage, which we believe is favorable compared to what we expect to incur going forward. We are actively managing both our equity and debt strategies, particularly in the fourth quarter where we see appealing pricing. We positioned ourselves early in the year by placing some of our debt, anticipating rising rates, but even if rates increase over time, they remain historically attractive. Our ability to invest, especially in development, remains strong in the mid-six to seven range. We aim to maximize our yield spread without putting excessive pressure on it. We will continue to engage in both debt and equity, maintaining a conservative balance sheet. Our strategy has been to ensure that if the equity markets shift, our debt position allows for ample flexibility. Given the current attractiveness of both sides, we will likely continue to pursue both avenues.

And just to squeeze one more from Marshall, any read-throughs on what could potentially happen with cap rates?

So far, we haven't observed any significant changes. As the debt market rises, cap rates have remained stable. It's challenging to say they're decreasing, but they may be slightly. Over the past year, we've noticed a differentiation in cap rates—previously, outside markets like Dallas, L.A., and Atlanta had slightly higher cap rates compared to markets like Phoenix, Las Vegas, Denver, and Charlotte. However, these secondary markets are becoming increasingly competitive, with asset pricing not differing much from Southern California. There continues to be substantial capital available, including from us, that favors well-located and well-designed industrial properties. We’ve learned that merely having funding is not an advantage in bidding since many competitors are also looking to acquire industrial assets. Hypothetically, until there is more comfort in underwriting office buildings along with considerations for remote work, retail, and hotels, the industrial market feels increasingly crowded with new competitors entering, depending on the specific market.

Thank you.

Sure.

Marshall, I just wanted to touch on your commentary about e-commerce. We all know it's extremely strong and definitely the demand is broadening out beyond Amazon, but just curious. This is a tenant debt that's come into your market more recently and the CFO was recently saying they're going to moderate their appetite for industrial. I'm just curious your thoughts on that, whether you've seen anything on that?

I'm not familiar with the specific tenant, but generally, we believe that both e-commerce and delivery are increasingly utilizing many of our buildings. There will be a continuous shift away from traditional brick-and-mortar stores toward a more integrated retail experience. This may involve having a prototype retail store in town, with the possibility of having more locations. We see curbside pickup as a desirable trend, and we are aware of some tenants that have adapted to this model within our properties or designated areas for this purpose, particularly in sectors like home improvement with companies like Ferguson Plumbing and Dal-Tile. As one of our directors noted, when COVID-19 hit, it made e-commerce more accessible to a larger part of the population, and this trend is still growing. The rapid expansion of Amazon in recent years means that retailers must think about how to speed up their delivery times to remain competitive, as Amazon continues to diversify into various sectors, adding pressure on other retailers to keep up with this growth.

Your perspective is that even if Amazon slows down, there remains substantial demand from other competitors, which should prevent any significant decline. I'm optimistic about this. However, consider that Amazon has acquired a vast amount of space. Retailers like Lowe's, Home Depot, Best Buy, and others, including online mattress providers, will need to adapt. There’s potential for pharmaceuticals to increasingly shift online as a cost management strategy. These retailers will need to adjust their strategies to enhance their delivery capabilities to compete with Amazon, especially as many consumers find online shopping convenient compared to traditional shopping, particularly during COVID. I believe brick-and-mortar stores will persist as they offer a social experience, but they will continue to evolve and capture a larger share of the retail market.

Okay. That's helpful, then just on development, you guys what you started subsequent to year-end, you're already 1/3 of the way to your development start guidance. As you look at the runway, you mentioned you had a big development last year, but do you guys feel you can close the gap relative to what you did in '21? And then just also on the yields. And I know you guys get asked all time. Yields are sticky in that high 6% range despite inflation and higher land costs. Do you feel like the market rent growth aspect of things could continue to keep yields up at that area?

I hope so. We'll proceed at the pace the market allows for leasing our buildings. Last year, we started with $205 million in projects and finished at $340 million, thanks in part to a $90 million pre-leased deal. I'm optimistic about a strong market and hope the leasing activity increases on our developments, enabling us to exceed the $250 million target. We have indeed commenced many projects this quarter, and we're noticing positive leasing activity and improved occupancy compared to the previous quarter. There seems to be potential for further growth. Regarding our development yields, we underwrite using current construction costs and rental rates to avoid challenges with future projections. We've observed some decrease in returns, but by the time we deliver the buildings in six to eight months, we often recover our position as leasing begins. Our recent data shows that we pulled 17 projects from the development pipeline last year, totaling about $280 million, achieving an average yield of 7.2%. Even if we adjust for some yield reductions, if we achieve a 70% to 75% value creation factor, that's still an excellent return. The key is to proceed as quickly as we can, but it ultimately depends on how quickly our developments lease up. Additionally, in the fourth quarter, we focused on finding vacancy and value-add opportunities that align with current demand while acquiring land sites amid significant competition. We are witnessing strong demand from industrial tenants and record absorption across most markets. Our goal is to find land that makes financial sense. We're concentrating on creating value, especially given the competitive nature of core leased assets. We aim to maintain favorable yields even as prices rise, and we hope to offset cost increases with rental growth.

Great. Thanks.

You're welcome.

The next question comes from Manny Korchman from Citi. Please go ahead.

Hey, it's Chris McCurry with Manny. I was wondering if you could comment on on-shoring trends and specifically the impact of labor cost, inflation, and just hiring shortages on any of these conversations?

Yes, that's a great question. It's challenging to categorize it strictly as on-shoring. What we've observed is a number of tenants relocating from California to states like Arizona, Nevada, and Texas, as well as an increase in relocations to Florida. We certainly notice population growth. Regarding on-shoring, as we've previously mentioned, due to labor shortages and rising labor costs, we're more optimistic about near-shoring. It may take some time, but we are considering moving plants to locations like Juarez, where we have a presence in El Paso, or from South San Diego to Tijuana, or even Nogales, Mexico, which is close to our properties in Tucson and Phoenix. Long term, we maintain a positive outlook on near-shoring, particularly with ongoing trade tensions with China that began before COVID, alongside the challenges posed by supply chain issues. It will likely take time to relocate operations to Mexico, but it seems more feasible compared to starting a new manufacturing site, especially in competitive labor markets like Atlanta or Dallas. For companies like Home Depot, transitioning suppliers from China to Mexico might prove to be a better strategy than trying to expand operations in those tougher markets.

Got it. Just one more from me, and I guess it builds off that, but with some of those reassuring conversations and just like supply chain issues in general, are those impacting any real estate decisions for some of your outdoor and home-building tenants or have you seen any long-term or near-term change in trends with those two categories?

We have been focusing on our strategy and are currently engaged with one of our prospects who is interested in near-shoring and logistics. There has been recent communication from their real estate team, and even their CEO has been touring some of the properties. We recently leased a building in Atlanta to a German automotive company about eight or nine months ago, and we are noticing similar movements in home building. The demand for housing is increasing in areas like Florida, Georgia, and Arizona, leading to more activity among our tenants. For example, we just leased a building in Fort Myers to a Canadian company that provides services to the home building industry. Additionally, we've observed a trend where single tenants are taking entire buildings we've designed for multiple tenants. This helps expedite our development pipeline, allowing us to quickly move on to the next project in the park.

Got it. Thank you.

Sure. You're welcome, Chris.

Our next question comes from Samir Khanal from Evercore ISI. Please go ahead.

Hey, Marshall. Good morning here. I guess my question is around the guidance sort of 55 at the midpoint for NOI, which is similar to what you did in '21. But considering how strong demand is and all the rent growth you hear about, I would've thought that would've been a little bit higher. Just trying to figure out, are there any headwinds we need to think about or contemplate to get your midpoint or even the low end here, which is the 51? And I guess I'm trying to see how much conservatism you're baking in here. Thanks.

This is Brent. Our midpoint guidance is 97%, which would mark our second-highest year on record if we achieve it. This translates to a 5.6% same-store midpoint. A significant part of that is due to occupancy levels increasing. We're not really factoring in occupancy as a contributor to same-store growth, so our focus is primarily on rental rate increases, which have been strong for us. We’re seeing low 30% GAAP returns and high cash returns. We anticipate similar record results, but we hope to achieve even higher increases as the year progresses. It’s still early in the year, and the complexities of looking at assumptions while analyzing field data on rollovers and vacancies can be tricky. If rental rate growth continues, it could provide us with more opportunities to exceed our targets. This midpoint is essential for our FFO guidance. Overall, we may be taking a more conservative approach in our development and speculative leasing within our overall budget compared to our operating side.

That's it from me, guys. Thanks.

Thanks.

Thank you.

The next question comes from Vince Tibone from Green Street Advisors. Please go ahead.

Hi. Good morning. Could you discuss the supplier landscape for shallow bay products in your markets? Are there any regions or metros where supply is potentially becoming a concern?

Hey, Vince, good morning. It's Marshall. I'm really not concerned about supplies. Generally, if we were building a model, a good rule of thumb is that in markets with a lot of activity, like Dallas where there are 55 million square feet under construction—likely a record—last year we saw absorptions of 40 million square feet, with over 60% of that in South Dallas and North Fort Worth, which we are not targeting. Usually, our team estimates that shallow bay represents about 10% to 15% of the total market supply. In looking at my market numbers, CVR's figures for Atlanta show just over 35 million square feet under construction, with only 76,000 square feet of shallow bay designated, which is minimal. There’s more competition, and I believe 10% is better than the 76,000. Tenants seem to have options, but if we were starting a development company, I would focus on building a larger facility, like an 800,000-square-foot building, rather than a 120,000-square-foot multi-tenant building, since many of our competitors are larger. Even local and regional developers are better off building bigger facilities. That’s where we see a lot of competition, and while those buildings are getting leased and working for others, it’s just not our niche. We aim to align more closely with demand, but local developers tend to fill smaller gaps, and there isn’t much shallow bay supply. I hate to say it on a public earnings call, but much of our competition is in larger, bulkier buildings.

That's really helpful, and I find it interesting that given the profit margins, East Group has developed that strategy in recent years. It's surprising that more people aren't pursuing a similar approach, but it makes sense considering the different perspective you outlined. So that's really helpful.

I believe part of the challenge, Vince, is that it's quite difficult to find good infill land sites. We're trying to work out how to fit multiple buildings into our parks, which makes the zoning and entitlement processes take longer compared to developments on the outskirts of town. Fortunately, with the remodel, we can take a few years to navigate this, like with the Charlotte land we closed; we had that under contract for about a year and a half before finalizing it. This approach differs from many private developers, as we have the advantage of being patient and focusing on these projects. It feels like we are diligently working on something that remains largely unseen until we successfully close on it.

Got it. That's all helpful commentary. Thank you.

Thank you. You're welcome.

Thanks, Vince.

The next question comes from Jason Idoine from RBC. Please go ahead.

Hey, good morning, guys. Quick question on the disposition of funds. So you guys had your first normal disposition of the year in the fourth quarter and then started the year with another disposition. So I guess my question is, what led to the determination to prune these properties from the portfolio? And what are some of the common characteristics that you're looking at when you decide maybe where you've maximized value?

Great question, Jason. The Tampa property, which we acquired in the '90s, is well-located but has many small tenants, and some of the buildings lack sprinklers. As we evaluated it, we approached it like a batting order. Fortunately, our team performed well, achieving just under a 4% cap rate for a project that is going on 40 years old. For the Phoenix property, we initially anticipated closing last year, but after changing buyers and having a backup buyer, it extended into the first week of this year. This property is also one of our few service centers, acquired in a portfolio during the '90s, and it was just at a 4% cap rate as well. I believe the demand for industrial properties is strong; I would have expected both to fall in the 6% to 7% cap rate range in 18 to 24 months. However, we managed to secure both at around 4%. Currently, we have another small service center listed in South Florida. As we continue to develop and create value in Houston, we have another project there. Properties with more office components or older buildings remind us of our responsibility to regularly prune our portfolio. We typically ask the team that if they received a call in the morning about a tenant going bankrupt, which building do they hope it’s not in. That helps to shape our disposition list. We favor settling things, preferably selling at a 4% in Tampa and developing towards the 6% to 7% range. This has been our strategy in Houston over the last few years, where we see development opportunities. We’ve also managed to sell in the 3% to 4% range when possible, maintaining that model.

Okay. That makes sense. And then touching on Houston, I know on the last call you guys mentioned that you expected that exposure to drop further, and I guess I was just trying to put some rails around that. So is that from selling assets or is that more just from growth in other markets?

It's been a mix, primarily driven by growth and increasing rents in other markets. We still have a positive outlook on Houston, supported by our strong team there, as it's the fifth largest city in the country for value creation. However, we are currently under contract for something else, so we will maintain our position in Houston for now while other markets where we are underexposed continue to grow. Fortunately, our projected net operating income has decreased to below 11%, and we see it trending downward. While we don’t plan to exit Houston entirely, we prefer a geographically diverse portfolio and recognize that we've been overly concentrated in that area in the past. I’m pleased that our Houston exposure has dropped below 11% this year.

Okay. And then with all the changes in the energy markets, I guess are you seeing any changes in the underlying key drivers in Houston? Are you seeing some of that excess supply maybe get absorbed more quickly or any changes on that front?

Houston has many markets, and last year's record absorption was 28 million square feet, which is significant. Currently, there is just over 18 million square feet under construction in Houston, with a 40% lease rate. The market has definitely improved over the last two years, and Houston is likely better off now than at any point in the last few years. We were questioning the situation when oil prices reached $90 a barrel, as there is considerable uncertainty in that industry. We are experiencing demand in Houston, but I don’t believe it’s due to an increase from oil and gas companies. It’s more about tenants we’re seeing in other markets. While we are not observing this trend in Houston, other markets are seeing energy-related tenants, particularly in green energy. For example, there’s a company converting buses from gas to electric and another producing electric batteries. These energy-related tenants are appearing in markets like Phoenix, Greenville, South Carolina, and Atlanta but not in Houston.

Okay. Thank you.

Sure.

Good morning. Can you comment on your bad debt reserve for your 2022 guidance? I remember back in 2019, you mentioned signing a number of leases with Peloton.

Good morning. This is Brent. Regarding our bad debt guidance of $1.5 million, last year was quite an anomaly for us, as we actually had a bad debt recovery of $475,000. Just to remind everyone, a year ago we had a deeper reserve allowance, not knowing how things would unfold. It’s hard to believe, but a year ago, we were still waiting for a vaccine. This year, our allowance has decreased as the year has progressed. Last year, we had 26 tenants included in our total reserve; now, as we start January, we only have 12 tenants. Therefore, I don't expect there to be as much reversal of bad debt to offset the potential bad debt this year. Looking at historical trends, the $1.5 million represents 0.33% of our revenue, based on our historical average. I hope we can surpass that, but with 1,600 to 1,700 tenants, considering the size of each and their straight-line balances, we're going to be more focused on our past performance rather than just taking a quick look. Regarding Peloton, we have leased space to them in South Florida and possibly a few other markets. Currently, there have been no issues with them. Although they have been in the news recently, they are not one of our top ten tenants. It seems their credit could improve depending on developments, but thankfully, we haven't had to directly address any concerns related to them.

Great. Thank you. And where would you guys like your Houston exposure to be, ideally?

Certainly, it will be under 11%; the reality is that it will likely continue to drift down. We have mentioned aiming for a low under 10%. My goal is always to have flexibility in any market in case an opportunity arises. I believe we can maintain it under 11%, unless we make a significant acquisition. However, over the next year or two, it will probably continue to drift down, and you can expect to see it below 10% in the next 12 to 18 months.

Great. Thank you.

You're welcome.

The next question comes from Ronald Camden, from Morgan Stanley. Please go ahead.

Yeah, it's me for Ron Camden. Keena talked a little about the guidance reflecting conservative assumptions with the speculative leasing. Just maybe you could provide some color on the type of leasing you're expecting with the current development pipeline, how that compares to the 2021 levels. I'm just thinking about 2021 and how the same-store guidance was roughly in line but FFO ultimately came in ahead.

You are referring to a comment I made earlier regarding a general assumption about our development income, which is largely covered by the budget for existing and prior leasing agreements. Many leases are not included in the same-store metrics. Any assets that qualified for the same-store mix would have been effective January 1, 2021. We have significant activity during this interim period, so much of that income is accounted for. From an operational perspective, with occupancy rates at 97% or 98%, analyzing the rent roll and rollovers shows that if we maintain a tenant retention rate of about 75%, it’s easier to project. In contrast, our development income tends to be more speculative in nature, which presents challenges since we do not have tenants secured for those projects yet. The timing involved in securing tenants, obtaining permits, and completing build-outs can make those projections more difficult. Therefore, we tend to be conservative with our assumptions regarding that side of the business. The differences in projections can be hard to quantify due to delivery times and other factors. However, we have potential growth on both the operating and development fronts. As reflected in our guidance, acquisitions and dispositions are expected to offset each other, meaning any potential acquisitions would be a positive addition, although we currently have nothing under contract at this time.

Yeah, that makes sense.

The next question is a follow-up from Elvis Rodriguez from Bank of America. Please go ahead.

Hey guys, just a quick follow-up on mark-to-market for the entire portfolio, are you able to share on a GAAP and cash basis? Thank you.

Not very well and not accurately. We don't know how our peers are performing in this regard. We have observed from other sectors that it's easier to manage in office spaces compared to retail and industrial settings, due to factors such as the availability of endcap spaces or air-conditioning. In terms of mark-to-market, our GAAP figures have been in the low 20s, with 22% in 2019 or 2020, and 31% in 2021. Some of this is influenced by the lease mix, as we had several large leases that allowed us to benefit from significant increases last year. I would feel comfortable projecting GAAP numbers in the 20s this year, and if we can reach 30%, that would suggest rent pressures and potentially the mix of leases rolling over. On a cash basis, we are likely in the teens for the mark-to-market figures, and we are noticing that the annual increases in many markets, which used to be 2.5% to 3%, are now moving to 3% to 4%. This trend will positively impact our GAAP increases. However, predicting these numbers can be challenging and will vary by quarter depending on the lease mix that rolls over. I would anticipate being back in the upper teens on a cash basis and in the 20s, possibly reaching 30% if we push for it, and I hope I am being conservative in my rent increase expectations for this year.

It's Marshall, and you made a good point about the new leases having higher rental bumps. Can you discuss what percentage of the leases are above 3% today and what you're seeing regarding your ability to achieve 4% across markets?

I think the positive aspect is that we could aim for 4% in the market if it's necessary. Given the tightness in the market, we've noticed our competitors doing this more frequently. This trend has emerged over the last 12 to 18 months. Typically, we renew about 14% to 15% of our portfolio each year, and since the market has just reached this point in the last year, we still have substantial room to increase rents further. We recognize that supply chain challenges, particularly in acquiring roofing materials and steel, have made delivery more expensive and time-consuming. This creates complications for the 2.5 million square feet we're actively developing, but it’s positive for the 50-plus million square feet that we already own. Therefore, we expect those 4% increases to be common across the market. We will be able to raise rents as leases renew, which is why we favor GAAP rent metrics. Additionally, we are noticing a reduction in the free rent periods. Tenants often express concerns about moving costs, leading us to sometimes include some free rent, but there is also downward pressure on free rent in the current market.

Great. Thank you.

You're welcome.

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